Bull Market Lives in U.S. Treasuries

As Treasury market rallies amid federal monetary policy speculation, Deutsche Bank predicts 2.25% yields in 10-year Treasuries at year-end.

Deutsche Bank AG was one of the few firms surveyed by Bloomberg in January to correctly predict the worst rout in the U.S. Treasury market since 2009. Now, Germany’s largest lender says it’s time to buy.

“The economy isn’t growing as strongly as we’d hoped,” Dominic Konstam, the New York-based global head of interest-rate research at Deutsche Bank, said in a telephone interview on Oct. 28, one day before a measure of U.S. consumer confidence plunged by the most in more than two years.

Given up for dead less than six months ago by Bill Gross, who oversees the world’s biggest bond fund at Pacific Investment Management Co. (Pimco), the three-decade bull market in debt is showing renewed strength as indicators such as retail sales and jobs growth falter. Last week, a Citigroup Inc. index showed that U.S. economic data began to fall short of analysts’ estimates for the first time in three months.

Speculation has switched from how soon the Federal Reserve will pare its unprecedented stimulus to how long it may need to wait with the world’s largest economy weakened by a 16-day government shutdown and policy makers falling short of their goals for employment and inflation. Deutsche Bank, which at the start of the year forecast 10-year Treasury yields would rise to 2.75 percent by Sept. 30, now says they will end the year at 2.25 percent, down from last month’s high of 2.73 percent.

“The idea that we have very strong growth and that they’re trying to have a meaningful reduction in monetary policy accommodation, that hypothesis is looking very damaged,” said Konstam, whose firm is one of the 21 primary dealers of U.S. government securities obligated to bid at Treasury auctions.

Konstam isn’t alone. Firms from ING Groep NV to SEI Investments Co. have boosted their holdings of Treasuries since September as growth prospects diminished, while a weekly survey by Stone & McCarthy Research Associates showed the proportion of U.S. government debt held by money managers increased in the week ended Oct. 29 from the lowest since June 2012.

Lower borrowing costs are key for the Obama administration and the Fed as they seek to foster the U.S. recovery after its worst recession in seven decades. The Treasury Department faces a record $1.38 trillion in notes and bonds due next year that it will need to repay or refinance.

Yields on 10-year Treasuries, used to help set interest rates on everything from mortgages to car loans, have decreased 0.37 percentage point since this year’s high on Sept. 5 as the shutdown boosted speculation the Fed will prolong its buying of $45 billion in Treasuries and $40 billion of mortgage-backed bonds each month to support the economy.

 

Diverging View

The rally in the Treasury market has mirrored those for fixed-income securities worldwide in the past month as bonds of issuers from Morgan Stanley to the Mexican government erased their losses for 2013, driven by speculation the Fed will keep flooding the financial markets with cheap money.

The Bank of America Merrill Lynch Global Broad Market Index’s 0.91 percent return last month pushed gains to 0.44 percent for the first 10 months of the year. Eight weeks ago, before Fed policy makers surprised investors by maintaining stimulus, the gauge was down 2.1 percent.

The rebound has alarmed BlackRock Inc.’s Laurence D. Fink, who said last week that the Fed’s decision is now contributing to “bubble-like markets.”

“It’s imperative that the Fed begins to taper,” Fink, who oversees $4.1 trillion in assets as chief executive officer of the world’s largest money manager, said Oct. 29 at a panel discussion in Chicago. “We’ve seen real bubble-like markets again.”

 

‘Sticking Power’

The four other firms that joined Deutsche Bank in correctly predicting at the start of 2013 that Treasury yields would rise, including Jefferies Group LLC and Credit Agricole SA, are all forecasting higher U.S. borrowing costs by year-end.

The jump in asset values may be one reason pushing the Fed toward tapering, David Zervos, the New York-based head of global fixed-income strategy at Jefferies, said in an Oct. 30 interview. By year-end, he expects 10-year yields will increase to 2.8 percent and reach 3.4 percent by June.

The economy will quickly regain its momentum as companies start to hire more workers, giving the Fed enough evidence to taper in January, according to David Keeble, the New York-based head of fixed-income strategy at Credit Agricole.

“Once you get into the taper talk, yields can spike mightily again,” Keeble said in an Oct. 30 phone interview. Demand for Treasuries don’t have “much sticking power.”

He projects that 10-year yields will end the year at 2.85 percent and rise to 3.2 percent in June.

Yields on Treasuries climbed higher last week as the Institute for Supply Management’s factory index showed some parts of the economy already started to recover. Manufacturing grew in October at a faster pace than economists forecast, with the index climbing to the highest level since April 2011.

The Fed also refrained from providing stronger signals of prolonged stimulus in a statement after its Oct. 29-30 meeting, signaling diminishing concern over higher borrowing costs as they maintained the pace of bond purchases and sought more evidence of sustained growth.

Yields on the 10-year notes rose 0.11 percentage point to 2.62 percent last week, Bloomberg Bond Trader prices show. The yield on the benchmark security dropped two basis points to 2.6 percent at 12:30 p.m. in New York.

At the start of the year, Frankfurt-based Deutsche Bank predicted in a Bloomberg survey of 75 forecasters on Jan. 4-9 that yields would eclipse 2.5 percent by the third quarter as a strengthening economy bolsters speculation the Fed would start paring stimulus.

The average estimate called for yields on the 10-year notes to reach 2.09 percent, from 1.9 percent when the survey was published. Yields started to climb from a low of 1.63 percent in May, prompting Gross, co-chief investment officer at Newport Beach, California-based Pimco to say on May 10 that the bull market in bonds probably ended.

Fed Chairman Ben S. Bernanke said later that month that policy makers could taper their bond buying in “the next few meetings” if the U.S. showed sustained growth.

By Sept. 30, 10-year yields had soared to 2.61 percent, rising almost a percentage point from the end of May in the biggest surge since the first four months of 2009 and putting Treasuries on course for their first annual loss in four years.

Konstam’s year-end forecast of 2.25 percent is now lower than 64 of 65 estimates in a Bloomberg survey and more than a half-percentage point below the average 2.79 percent projection.

 

Economic Growth

Economists predict the Fed will maintain the current pace of purchases until March, a Bloomberg survey on Oct. 17-18 showed. They cut their forecast for fourth-quarter growth to 2 percent, according to the median estimate in an Oct. 31 survey, from 2.4 percent prior to the shutdown.

“The uncertainty generated by that shutdown is likely to be enough to keep the Fed’s position on tapering on hold for longer,” Jake Lowery, a money manager at ING U.S. Investment Management, which oversees $120 billion of fixed-income assets, said in an Oct. 29 telephone interview from Atlanta.

Lowery began buying Treasuries after yields on the 10-year note reached this year’s high of 2.99 percent in September.

Indicators gauging the health of the economy fell short of analysts’ estimates last week for the first time since July, the Citigroup Economic Surprise Index showed. The minus 2.1 reading on Oct. 30 compares with 53.3 at the start of the month.

U.S. consumer confidence slumped in October, with the Conference Board’s index falling by the most since August 2011. The reading was the lowest in six months and less than the median forecast in a Bloomberg survey.

The decline may hold back the household purchases that make up 70 percent of the economy as the U.S. enters the holiday shopping season. Wal-Mart Stores Inc., Macy’s Inc., and Nordstrom Inc. all cut their forecasts on concern demand will falter in the Thanksgiving-to-Christmas season.

Even before the shutdown, the economy showed signs of cooling. Retail sales slowed in September as Americans became less upbeat about their finances and curbed spending.

“The overall backdrop of softer economic data that we’ve been starting to see” has made Treasuries more attractive, Sean Simko, an Oaks, Pennsylvania-based money manager at SEI, which oversees $8 billion, said in an Oct. 29 telephone interview. “We had the sense that the data was going to slow, and with the government shutdown imminent at the time, we thought it would create” a buying opportunity.

He began to buy seven-year and 10-year notes in September.

 

No Brakes

Demand for government bonds is unlikely to decrease as long as the weakened economy prevents the Fed from fulfilling its targets, according to Robert Tipp, the chief investment strategist at Prudential Financial’s fixed-income division, which oversees $395 billion in bonds.

Joblessness is at 7.2 percent—versus 5 percent when the 18-month recession began in December 2007—and above the 6.5 percent rate that the Fed said would prompt policy makers to consider raising short-term rates. Employers added fewer workers to payrolls than economists projected in September, the third straight month the data fell short of forecasts.

Consumer prices will increase less than the Fed’s target of 2 percent annually for at least three years, based on bond trading. The so-called break-even rate, or the gap between yields on Treasury Inflation-Protected Securities and fixed-rated Treasuries, indicates that inflation will rise an average 1.4 percent through 2016.

“Given how sluggish things are with households and the fact that you need more demand, they should really be keeping both feet on the accelerator,” Tipp said by telephone from Newark, New Jersey. “The economy is not rip-roaring. It would make sense to push back tapering for at least a year.”

The Fed is also considering standards that by 2017 will require the biggest U.S. banks to hold enough easily sold assets to survive a 30-day drought, a move that would compel the nation’s lenders to purchase more Treasuries.

Demand for Treasuries at government debt actions increased in successive months for the first time in a year, as bids exceeded the amount of coupon debt sold in October by 2.85 times, the most since May.

Americans, who have the least amount of debt since 2002, are also holding more cash and investing their disposable income in bonds rather than spending, according to FTN Financial. That’s holding back growth in the U.S. economy and spurring more demand for Treasuries as the Fed maintains its bond buying, Jim Vogel, a Memphis, Tennessee-based interest-rate strategist at FTN, wrote in a report on Oct. 25.

“I would not have wanted to add too much” to our Treasury holdings a few weeks ago, said Jeffery Elswick, who oversees about $4.5 billion of fixed-income assets at San Antonio-based Frost Investment Advisors LLC and manages the Frost Total Return Bond Fund, which has beaten 95 percent of peers in the past three years. Now, “we have been recommending over the last week or so adding to Treasury positions.”

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