By Daniel Kruger
Sept. 28 (Bloomberg) — Federal Reserve Chairman Ben S. Bernanke has some good news for investors: Treasury bondholders will lose money for the first time in 10 years amid an unprecedented decline in the gap between the interest rate on 30-year mortgages and government notes, signaling an end to the worst financial crisis since the Great Depression.
Yields on benchmark 10-year notes will end the year little changed at 3.36 percent before rising to 3.65 percent by mid- 2010 as bond prices fall, according to the average estimate in a Bloomberg News survey of JPMorgan Chase & Co., Goldman Sachs Group Inc. and the rest of the 18 primary dealers that trade Treasuries directly with the central bank.
The 2.65 percent loss posted so far this year, as measured by Merrill Lynch & Co.’s Treasury Master Index, shows investors no longer require the refuge of U.S. government debt that led to a gain of 14 percent last year. Borrowing rates have declined on everything from mortgages to corporate bonds after the Fed and the government lent, spent or guaranteed $11.6 trillion to shore up banks and end the recession.
“The safe bet from here is a gradual rise in yields,” said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York. He expects 10-year yields in a range of 3.75 percent to 4.25 percent by the first half of 2010, compared with 3.25 percent to 3.75 percent now.
Getting It Right
Primary dealers, who underwrite the government’s debt and serve as the Fed’s counterparties in open market operations, predicted that Treasuries would fall as the year began. The first half was the worst for bonds since at least 1978, when Merrill Lynch began tracking the data. Investors lost 4.46 percent, according to the Merrill index.
The firms were right again in June when they forecast the worst was over. U.S. government securities returned 1.9 percent since midyear.
Rising yields coincided with signs President Barack Obama’s stimulus measures were spurring the economy at the same time as costs of credit for consumers declined, one of Bernanke’s main goals for this year. Gross domestic product increased 2.9 percent in the third quarter, according to the median estimate of 59 forecasts in a Bloomberg survey.
Home buyers now pay an average 5.19 percent on 30-year fixed-rate mortgages, according to Bankrate.com. That’s down from 6.46 percent in October 2008. The mortgages cost 1.88 percentage points more than yields on 10-year Treasuries, compared with 3.27 points in December, data compiled by Bloomberg show. The average gap for the five years ending with 2007 was 1.53 points.
Mortgage rates had climbed to the highest since 2002 in October after the bankruptcy of Lehman Brothers Holdings Inc. froze credit markets and the real estate market collapsed. The housing slump that caused the recession is easing as tax credits to first-time buyers and near record-low borrowing costs help stabilize prices. Purchases of existing homes rose 3.4 percent in August compared with a year earlier, the National Association of Realtors said Sept. 24.
Investors growing more comfortable with risk added about $295 billion this year to bond funds targeting debt including corporate bonds, bank loans and municipal notes, Bank of America Corp. analysts wrote in a Sept. 24 report, citing AMG/Lipper Data Services. Barclays Plc index data shows yields on high- yield, high-risk corporate bonds have dropped to 7.54 percentage points more than Treasuries, from a record high of 19.7 percentage points in December, reducing costs for companies.
Returns on financial assets jumped in the third quarter, except for Treasuries. Corporate debt gained 8.3 percent and mortgage-backed securities returned 2.26 percent during the period, Merrill data shows. The Standard & Poor’s 500 Index advanced 14 percent after rising 15 percent the previous three months, the biggest back-to-back rallies since 1975.
The 10-year note yield was little changed at 3.31 percent at 9:23 a.m. in New York, according to BGCantor Market Data. The 3.625 percent security due August 2019 fell 15 basis points last week, or 0.15 percentage point, rising 1 9/32, or $12.81 per $1,000 face amount, to 102 17/32.
Yields will rise as the economy expands 2.2 percent in the fourth quarter, the pace of job losses slows, the government sells record amounts of debt and the Fed completes its $300 billion in purchases of U.S. securities next month, according to economist surveys.
The central bank will raise its target interest rate for overnight loans between banks by April, based on futures data compiled by Bloomberg. Central bank officials said in a statement last week after leaving borrowing costs unchanged that data indicates “economic activity has picked up following its severe downturn.”
Most dealers forecast that yields will remain near current levels into 2010 with consumer prices falling 1.5 percent from a year earlier and foreign buyers increasing the pace of Treasury purchases as issuance of alternatives such as so-called agency securities decrease.
“The primary driver of our forecast is inflation,” said Michael Chang, a New York-based interest-rate strategist at Credit Suisse Group AG, which expects the Fed to keep borrowing costs in a record low range of zero to 0.25 percent through the second quarter. Citigroup Inc., Morgan Stanley, Daiwa Securities Group Inc. and UBS AG see an increase in the target rate before the last half of 2010.
Futures traded on the Chicago Board of Trade show 77 percent of bets projecting at least one Fed rate increase by the April 28 policy meeting.
‘Worst Is Over’
Year-end estimates for 10-year yields range from a low of 2.5 percent at Credit Suisse, to a high of 4 percent from Bank of America. BNP Paribas, Credit Suisse, Goldman Sachs, HSBC Holdings Plc and Mizuho Financial Group Inc. predict 10-year notes will fall from by the end of the second quarter.
“The worst is over for the economy,” said James Caron, head of U.S. interest-rate strategy in New York at Morgan Stanley, which expects 10-year yields to rise to 4.5 percent by June. “We are going to see higher yields going forward because we are going to have a slow recovery and inflation risk premiums will rise.”
General Motors Co., the Detroit-based carmaker that emerged from bankruptcy protection in July, said Sept. 22 that it will add a third shift at three plants taking on additional production from factories slated to be closed or idled, restoring 2,400 jobs. American Express Co., the New York-based payment-card company, said Sept. 24 that it plans to reverse some of the compensation cuts it imposed seven months ago.
Dealers are less pessimistic on bonds than most forecasters. Their 3.65 percent yield estimate compares with the average of 3.95 percent in a survey of 59 strategists and economists in a Bloomberg survey.
Inflation hasn’t been a problem yet. The difference in yield between Treasury Inflation Protected Securities and U.S. bonds, which represents the rate of price increases investors anticipate over the life of the securities, is 1.74 percentage points, compared with the average of 2.19 percentage points in the past five years and the median increase in the consumer price index during the period of 2.6 percent.
“The 10-year should move higher due to both supply and demand factors,” said Michael Pond, an interest-rate strategist in New York at Barclays. “The Treasury will sell more issuance out on the yield curve, which will send rates higher.”
The U.S. has sold $1.517 trillion in notes and bonds this year, compared with $585 billion in the same period a year earlier. Barclays forecasts the government will sell $2.1 trillion in debt this year and $2.5 trillion next, up from $892 billion for 2008.
While the U.S. has seen rising demand at its auctions so far, that may change, according to Barclays, which forecasts the two-year Treasury yield will reach 2.35 percent and the 10-year will touch 4.5 percent by June 30.
After purchases by the Fed, the net supply of long-term government and agency debt has been about $50 billion a month this year, Dean Maki, the head of U.S. economics research at Barclays in New York, wrote in a Sept. 4 report. As the Fed slows its so-called quantitative easing program, net supply may reach $200 billion by year-end, he said.
Demand from overseas investors exceeded the average so far this year, with foreign buyers taking 45.2 percent of the $43 billion of two-year notes, 44.8 percent of the $40 billion of five-year notes and 61.7 percent of the $29 billion in seven- year notes, according to Treasury data.
The stimulus undertaken by Bernanke’s Fed and the Obama administration have led to “a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability,” the Fed said in its statement.
The central bank has begun to scale back its support for financial markets, announcing last month that Treasury debt purchases will end in October, and started talks with primary dealers about withdrawing some of the $1 trillion injected into markets the last two years.
Central banks are discussing using reverse repurchase agreements to drain reverses, according to people with knowledge of the talks. In the transactions, the Fed sells securities to the dealers for a specific period, temporarily decreasing the amount of money available in the banking system.
“Rates are going to start drifting higher,” said Ward McCarthy, chief financial economist at primary dealer Jefferies & Co. in New York. “That’s going to start making the market a little nervous.”
Primary Dealer Year End/June 2010 Forecasts
Fourth Quarter 2009 Second Quarter 2010
BNP Paribas 0.75/3.25 0.85/3.00
Banc of America 1.00/4.00 1.45/4.20
Barclays Capital 1.30/3.85 2.35/4.50
Cantor Fitzgerald 0.90/2.90 1.50/3.75
Citigroup NA/3.70 NA/4.10
Credit Suisse 0.70/2.50 1.50/3.00
Daiwa Securities 1.25/3.50 1.80/4.00
Deutsche Bank 1.00/3.50 1.50/4.00
Goldman Sachs 1.00/3.10 1.00/3.00
HSBC Securities 0.90/3.00 0.90/2.50
Jefferies & Co. 1.15/3.50 1.35/3.65
J.P. Morgan 1.00/3.60 1.25/4.00
Mizuho Securities 1.00/3.25 1.00/3.00
Morgan Stanley 1.20/3.50 1.50/4.50
Nomura Securities 1.20/3.55 1.65/3.70
RBC Capital Markets 1.00/3.00 1.20/3.50
RBS Securities 1.00/3.00 2.00/3.50
UBS Securities 1.80/3.80 2.80/3.80
Average 1.07/3.36 1.51/3.65
Median 1.00/3.50 1.50/3.50
High 1.80/4.00 2.80/4.50
Low 0.70/2.50 0.85/2.50
To contact the reporter on this story: Daniel Kruger in New York at email@example.com
Last Updated: September 28, 2009 09:27 EDT