Tags: Pimco-BofA | Bonds | Yields | Eisenhower | Low

Pimco-BofA: Bonds Yields May Plunge to Eisenhower Low

Monday, 13 September 2010 11:59 AM

Bond investors are growing more convinced that Federal Reserve Chairman Ben Bernanke will push Treasury yields down to the levels of the 1950s with another round of asset purchases.

Goldman Sachs Group Inc. and Pacific Investment Management Co. project the Fed will resume quantitative easing by purchasing U.S. government debt as soon as this year to prevent what they see as a 25 percent chance the economy will slip back into a recession. Bank of America Corp. says the central bank will send the 10-year note yield to a record low of 1.75 percent in the first quarter of 2011.

Derivatives show investors are betting on lower yields at a rate not seen since the Fed began buying Treasuries in March 2009, even after companies in the U.S. added more jobs than forecast and manufacturing expanded faster than estimated in August. Policy makers are attempting to push borrowing costs lower and investors into higher-yielding assets such as corporate debt to help sustain the expansion and spur hiring.

“The Fed will have to be proactive and do quantitative easing as growth slides,” said Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch in New York. “The Fed will be aggressive with their purchases because they don’t want to run the risk of it not working and them losing credibility.”

Yields on 10-year Treasury notes, which serve as a benchmark on everything from mortgages to auto loans, rose last week as the U.S. sold $67 billion in notes and bonds and investor demand increased at debt auctions in Ireland and Portugal, easing concern European governments will struggle to finance deficits. The yield on the 2.625 percent note due August 2020 climbed 10 basis points to 2.79 percent, according to BGCantor Market data.

The rate rose 3 basis points to 2.83 percent at 6:55 a.m. today in New York.

Misra, ranked among the top three for U.S. government or federal agency strategy in Institutional Investor magazine’s poll of money managers from 2003 through 2008, projects the Fed will begin buying Treasuries in the first three months of next year. Bank of America cut its 2010 U.S. economic growth forecast on Sept. 1 by 0.1 percentage point to 2.6 percent and lowered its 2011 estimate by a half-point to 1.8 percent.

The economy expanded at a 1.6 percent annual rate in the second quarter, down from 3.7 percent in January through March, the Commerce Department in Washington said Aug. 27.

Only 723,000 people were added to company and government payrolls so far in 2010, or 8.6 percent of the 8.4 million jobs lost during the recession, which began in 2007 and is the biggest employment slump in the post-World War II era. The jobless rate, which reached a 26-year high of 10.1 percent in October, will average more than 9 percent through 2011, according to a Bloomberg News survey last month, as the U.S. fails to grow enough to employ people rejoining the labor force.

The world’s largest economy will expand an average 2.5 percent in 2011, less than the 2.8 percent projected last month and slower than an estimated 2.7 percent this year, according to the median of 59 forecasts in a Bloomberg News survey taken Sept. 1 through Sept. 9.

The pace of economic expansion has faltered even as the Fed kept its target rate for overnight loans between banks at zero to 0.25 percent since 2008, and bought more than $1.7 trillion in housing debt and Treasury securities last year.

Treasury purchases may total about $1 trillion in another round of quantitative easing, according to Jan Hatzius, chief U.S. economist for Goldman Sachs. The New York-based firm correctly project yields will slide in 2010 as the recovery faltered, and forecasts the 10-year note will end the year at 2.5 percent.

Hatzius predicted the most recent contraction about one year before the Cambridge, Massachusetts-based National Bureau of Economic Research declared the economy had slipped into one. Hatzius and his group at Goldman Sachs ranked No. 1 among economic forecasters for 2009, data compiled by Bloomberg show.

The NBER defines a recession as a “significant” decrease in economic activity over a sustained period of time, visible in gross domestic product, payrolls, industrial production, sales and incomes.

Investors have piled into Treasuries before as joblessness climbed. Bond yields slid in 1953 along with stock prices and again in 1958 as unemployment reached a nine-year high of 7.5 percent during the Dwight D. Eisenhower administration.

“The first half of 1958 was characterized by unprecedented speculation in government bonds,” according to “A History of Interest Rates” by Sidney Homer and Richard Sylla. Yields on 10-year notes reached as low as 2.29 percent in April 1954, monthly data collected by the Fed show. Ten-year yields slid to a record low of 2.04 percent during the height of the credit- market freeze in December 2008, according to Bloomberg data.

Some investors are now preparing for lower yields if the Fed expands its purchases of government debt. The central bank began using the proceeds from maturing mortgage holdings last month to buy Treasuries to keep its balance sheet at about $2 trillion and prevent reserves from leaving the banking system.

Demand for options on Treasury futures that protect against falling rates is outstripping that for swaptions, options on interest rate swaps, signaling an increased desire to hedge against falling Treasury yields.

The ratio of implied volatility, a barometer of price and demand, on swaptions relative to options on Treasury note futures is below 1 and last month reached the lowest in six years, according to data from London-based Barclays Plc. Options on the Treasury futures are historically less expensive, causing the ratio to be greater than 1, because Treasury yields are more stable than swap rates.

“The options’ ratio shows that investors are worried about and believe in the possibility of the Fed doing a second round of quantitative easing,” said Piyush Goyal, a fixed-income strategist at Barclays Capital in New York. “Investors are bidding up the price of options on Treasury futures because these options will give more bang for the buck if yields fall.”

Traders are also buying Treasury futures contracts that will rise in price if yields slide.

The number of contracts hedge funds and other large speculators hold betting on an increase in the price of the 10- year note futures exceeded those counting on a drop in the week ended Aug. 31 for the first time since February 2009, according to data from the Washington-based Commodity Futures Trading Commission. The so-called net long position was 62,919 contracts, after a net-short position of 274,741 in April.

“We still have a very meaningful probability of a double- dip scenario and the Fed should think in terms of taking out insurance on that scenario,” Paul McCulley, a portfolio manager at Newport Beach, California-based Pimco, said during an “In the Loop” interview on Bloomberg Television with Betty Liu on Sept. 3, citing the chance of the economy dropping back into recession.

Pimco, the world’s largest manager of bonds funds with more than $1.1 trillion of assets, has called for a “new normal” in the global economy that will include heightened government regulation, lower consumption, slower growth and a shrinking global role for the American economy.

“There’s going to be a distinction though between the impact of QE2 on financial markets, which will be to lower yields and raise the price of Treasuries, and the impact of QE2 on the economy, which is going to be muted,” Pimco Chief Executive Officer Mohamed El-Erian said in a Sept. 10 radio interview on “Bloomberg Surveillance” with Tom Keene.

Robert Lucas, a professor of economics at the University of Chicago, is unconvinced that buying government debt will provide the stimulus to spur job growth or investment.

“For the economy as a whole I don’t see the payoff from more quantitative easing,” said Lucas, winner of the Nobel Prize in 1995. “The economy recovers from recessions, even though it’s never as fast as we want it to, through a lot of natural forces working in that direction.”

Any further drop in bond yields may benefit the administration of President Barack Obama by cutting the cost of servicing record U.S. debt, along with companies seeking to borrow. While the government has increased the amount of marketable Treasuries by 70 percent to $8.18 trillion in the past two years, rising demand has driven yields so low that interest to service the debt has fallen 17 percent so far in fiscal 2010 ending Sept. 30 from all of 2008.

Home Depot Inc., Round Rock, Texas-based Dell Inc. and Burlington Northern Santa Fe LLC of Fort Worth, Texas, led the busiest day for U.S. corporate bond issuance in more than seven months on Sept. 7 with investment-grade borrowing costs near the lowest on record. Companies sold $15.4 billion of the debt as yields fell to 3.83 percent that day and reached as low as 3.74 percent on Aug. 24, according to Bank of America Merrill Lynch’s U.S. Corporate Master index.

“We couldn’t have timed it better,” Carol Tome, Atlanta- based Home Depot’s chief financial officer, said in an interview on Sept. 9. “Interest rates will stay low for a while. Just look what the Federal Reserve has said about interest rates.”

In the U.S., junk-rated borrowers have sold more than $163 billion of debt this year, already topping the 2009 record of $162.7 billion, according to data compiled by Bloomberg.

The average rate on a 30-year fixed mortgage increased to 4.50 percent in the week ended Sept. 3 from 4.43 percent the previous week, which was the lowest in data going back to 1990.

“Bernanke has made it very clear that he’d much prefer to do nothing and let the economy slowly stabilize and work its way out of its difficulties but that he will act if necessary,” said Andrew Milligan, Edinburgh-based head of strategy at Standard Life Investments Ltd., which oversees about $221 billion. “So the bond market is watchful and wary of the next Fed speech, statement or decision.”

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Bond investors are growing more convinced that Federal Reserve Chairman BenBernanke will push Treasury yields down to the levels of the 1950s with another round of asset purchases. Goldman Sachs Group Inc. and Pacific Investment Management Co. project the Fed will resume...
Monday, 13 September 2010 11:59 AM
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