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Treasury Inflation Bets Climb to Five-Month High on Fed Outlook

Tuesday, 26 October 2010 07:21 AM

Treasury-market inflation bets rose to a five-month high as traders forecast the Federal Reserve will increase bond purchases to spur the economy.

Mohamed A. El-Erian, chief executive officer at Pacific Investment Management Co., led analysts and investors who say so-called quantitative easing will drive up costs. Kansas City Fed Bank President Thomas Hoenig said the strategy would be a “dangerous gamble.” John Brynjolfsson, chief investment officer at Armored Wolf LLC hedge fund, called Fed purchases a “bazooka.”

“The kinds of yields we have on long-term Treasury debt are unsustainable” and will head higher, Brynjolfsson said. “The Fed is successfully avoiding deflation.”

Benchmark 10-year securities yielded 2.55 percent as of 6:46 a.m. in London, according to BGCantor Market Data. The 2.625 percent security due in August 2020 traded at a price of 100 19/32. Two-year notes yielded 0.36 percent, versus the record low of 0.327 percent set on Oct. 12.

The difference between rates on 10-year notes and Treasury Inflation Protected Securities, a gauge of trader expectations for consumer prices, widened to 2.18 percentage points, matching the most since May 19.

A $10 billion sale of five-year Treasury Inflation Protected Securities drew a negative yield for the first time at a U.S. debt auction yesterday as investors bet the Fed will be successful in sparking inflation. The auction yield rate was negative 0.55 percent.

The dollar traded near a 15-year low versus the yen on the outlook for Fed easing. The U.S. currency bought 80.63 yen, from 80.41 yen yesterday, the weakest level since April 1995.

‘Rally’s Not Over’

Treasuries still offer value, said Yusuke Tanaka, senior dealer for Mitsubishi UFJ Trust & Banking Corp. in Singapore, part of Japan’s largest publicly traded lender.

“The economy’s not improving,” Tanaka said. “The rally’s not over.” He plans to buy 10-year notes at a yield of 2.7 percent, he said.

Ten-year yields will be little changed at 2.57 percent by Dec. 31, according to a Bloomberg survey of banks and securities companies, with the most recent forecasts given the heaviest weightings.

U.S. unemployment has been more than 9 percent since May 2009. Home-price gains slowed and consumer confidence rose, economist said before two industry reports today.

“We don’t think home prices are going to get much lower than what they are today,” Larry Sorsby, chief financial officer at Hovnanian Enterprises Inc., the largest homebuilder in New Jersey, said during an Oct. 7 conference call. “Unfortunately, fear is outweighing affordability.”

Auction Demand

The U.S. is scheduled to auction $35 billion of two-year notes today, to be followed by sales of five-year debt tomorrow and seven-year securities on Oct. 28.

The two-year notes yielded 0.38 percent in pre-auction trading, versus the prior record low of 0.441 percent at the previous auction on Sept. 27. Investors bid for 3.78 times the amount on offer last month, versus an average of 3.20 for the past 10 sales.

Indirect bidders, the category of investors that includes foreign central banks, bought 39 percent of the notes, compared with the 10-sale average of 37.6 percent.

Rising costs for metals, food and oil show the central bank is preventing deflation, said Brynjolfsson, who is based in Aliso Viejo, California, in an interview yesterday on Bloomberg Television. Deflation is a general drop in prices.

Inflation ‘Bazooka’

“Their second goal is to achieve their target of 2 percent inflation,” he said. “The bazooka they have of quantitative easing should convince market participants that if that’s what they want, that’s what they’re going to get.”

The UBS Bloomberg Constant Maturity Commodity Index was about 1 percent away from a two-year high.

Fed Treasury purchases will spur global inflation while failing to bring down U.S. unemployment, El-Erian said yesterday. Pimco, based in Newport Beach, California, manages the world’s biggest bond fund.

The central bank announced Aug. 10 that it will reinvest principal payments from its holdings of mortgage debt in U.S. government securities. It plans to buy Treasuries maturing from February 2021 to August 2040 today as part of that plan, according to its website.

Fed ‘Terrified,’ Pimco Says

The Fed will probably add to its purchases at its next meeting Nov. 2-3, El-Erian said. The central bank “is terrified of deflation,” he said.

Hoenig, who has dissented from every Fed policy decision this year, also criticized the strategy.

“It is a very dangerous gamble,” Hoenig said in a speech yesterday in Lawrence, Kansas. “We risk the next crisis four or five years from now. Central bankers need to think of the long term.”

Near-record-low Treasury yields are prompting some money managers to seek higher rates in company bonds.

The extra yield investors demand to hold global bonds rated CCC or lower instead of government debt is about 10.2 percentage points, or 3.3 percentage points narrower than the average over the past 12 years, according to Bank of America Merrill Lynch index data.

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Treasury-market inflation bets rose to a five-month high as traders forecast the Federal Reserve will increase bond purchases to spur the economy.Mohamed A. El-Erian, chief executive officer at Pacific Investment Management Co., led analysts and investors who say so-called...
Tuesday, 26 October 2010 07:21 AM
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