Nov. 21 (Bloomberg) -- U.S. Treasuries, providing the worst returns since 1999, may rebound next year as the Federal Reserve's interest rate increases slow the economy and inflation, say the bond market's biggest investors.

Institutions that manage more than $1.3 trillion expect Treasuries to rise by June 30, according to a weekly survey by Ried, Thunberg & Co., a research unit of ICAP Plc, the world's largest inter-bank broker. Investors in the survey had been negative on U.S. debt for four years.

The lowest inflation rate in four months, consumer confidence at a two-year low and declining home prices show the central bank's 12 rate increases starting in June 2004 may be slowing U.S. growth. The difference between yields on two- and 10-year Treasuries narrowed to 0.08 percent on Nov. 16, the smallest gap since 2001, a sign to some investors that the Fed may raise rates too far and tip the economy into recession.

``Overshooting remains not just a risk, but increasingly a base-case scenario,'' said Paul McCulley, a managing director at Pacific Investment Management Co. The Newport Beach, California- based firm manages about $500 billion in assets, including the world's biggest bond fund. ``You always want to buy bonds on the eve of the last rate hike,'' he said.

Ried Thunberg's index of investor sentiment toward 10-year Treasuries reached 51 on Nov. 14, the highest since the September 2001 terrorist attacks. Readings above 50 by the Jersey City, New Jersey-based firm, indicate investors expect the note's price will be higher at the end of June. It has been at 50 or above for four straight weeks.

Market Rally

The yield on the benchmark 10-year note fell 3 basis points, or 0.03 percentage point, to 4.46 percent at 5 p.m. in New York, according to bond broker Cantor Fitzgerald LP. The price of the 4 1/2 percent note maturing in November 2015 rose about 1/4, or $2.50 per $1,000 face amount, to 100 5/16. The yield is down from a seven-month high of 4.68 percent on Nov. 4.

Some of the biggest bond market rallies came after the central bank stopped raising rates, Merrill Lynch & Co. index data show.

Treasuries returned 13.4 percent in 2000 when the Fed ended a series of six rate increases. That was the best performance since 1995, when returns averaged 18.5 percent after the central bank raised rates seven times. Government bond returns were 14.3 percent in 1989 as the Fed finished lifting rates.

This year, Treasuries are up 1.66 percent, the worst performance since 1999, when they fell 2.38 percent, according to Merrill indexes.

`Overshoots'

``The Fed likes to see financial conditions become restrictive and by definition, that means it overshoots,'' said Rajiv Sobti, head of trading in North America at Madrid-based hedge fund group Vega Asset Management LLC.

The economy grew 0.8 percent in 2001 after the Fed increased rates. In 1995, higher borrowing costs contributed to U.S. growth slowing to 2.5 percent from 4 percent the previous year. In 1989, the economy slowed so much that the Fed cut rates by mid-year.

Policy makers suggested they plan to keep raising borrowing costs at a ``measured'' pace when they increased their target rate for overnight loans between banks to 4 percent on Nov. 1. San Francisco Fed President Janet Yellen on Oct. 18 said a ``neutral'' rate, one that neither restrains nor sparks the economy, may be as high as 5.5 percent.

Interest-rate futures show traders expect three more increases by the end of March, bringing the rate to 4.75 percent. That's raising the prospect two-year yields will rise above those on 10-year securities, known as an inverted yield curve.

`Slow Sharply'

The past four U.S. recessions were preceded by an inverted curve. The last time the difference in yields was this small was January 2001, just as the Fed began a series of 11 rate cuts that reduced its benchmark rate to 1.75 percent from 6 percent in one year. The central bank added two more reductions, bringing the rate to a four-decade low of 1 percent in June 2003.

``The Federal Reserve raising rates is going to create overkill in the economy,'' said Michael Cheah, who manages $2 billion of bonds at AIG SunAmerica Asset Management in Jersey City, New Jersey. ``When the yield curve inverts, the economy will slow sharply. Banks will be lending money below cost, and they will not do it.''

Economic growth will slow to 3 percent this quarter from 3.8 percent in the June through September period, according to the median estimate of 63 economists surveyed by Bloomberg from Oct. 31 through Nov. 8.

Different This Time

``We believe the yield curve will invert slightly,'' said Nasri Toutoungi, a managing director who oversees $5 billion in bonds at Hartford Investment Management Co. in Hartford, Connecticut.

Toutoungi said an inverted yield curve may not signal a recession because yields are lower than in past cases, meaning they won't choke the economy. Ten-year Treasury yields averaged 6 percent in 2000 when the curve was inverted. The yield on the benchmark ended last week at 4.49 percent.

Investors turned more bullish on Treasuries as reports showed consumer prices rose 0.2 percent last month, the smallest increase since June. The New York-based Conference Board's consumer confidence index fell last month to the lowest since October 2003. On Nov. 4, a Labor Department report showed the economy added 56,000 jobs the prior month, less than half the median estimate of economists surveyed by Bloomberg News.

Inflation, Housing

Other indicators suggest higher rates are starting to crimp the real estate market, which accounted for 50 percent of the economy's expansion since 2001, according to an August report by Merrill.

An index of U.S. mortgage applications this month fell to the lowest since January as 30-year loan rates reached a two-year high of 6.36 percent, according to the Mortgage Bankers Association and Freddie Mac. The median price of a new home declined 9 percent from its peak of $237,300 in February, according to the National Association of Realtors.

Fed policy makers ``are going too far,'' said Andrew Harding, who manages $15 billion in bonds at Cleveland-based Allegiant Asset Management. ``We are seeing a flattening of housing prices and that's what the original target was'' for the Fed, he said.

The Fed may have a road map in its British counterpart.

The Bank of England increased rates five times between November 2003 and August 2004 to prevent annual increases in house prices of as much as 20 percent from fueling inflation. A year later, it lowered its benchmark rate a quarter point to 4.5 percent amid declines in property values and household spending.

The yield on 10-year gilts since the last BOE rate increase dropped about 80 basis points to 4.2 percent.

To contact the reporter on this story: Al Yoon in New York at ayoon@bloomberg.net.

Last Updated: November 21, 2005 17:09 EST