Treasury Yields Near One-Month Low on Fed Outlook, Signs Economy Slowing

Treasuries rose, pushing the two- year note’s yield to the lowest level this year, as the Federal Reserve signaled that European indebtedness may harm America’s growth and a report showed new home sales plunged.

U.S. debt advanced for a second straight day as the central bank reiterated its commitment to an “extended period” of low interest rates. Treasuries earlier pared gains as the government’s $38 billion auction of five-year notes drew a higher yield than forecast.

“Rates can stay very low for a long time,” said Jay Mueller, who manages about $3 billion of bonds at Wells Fargo & Co. in Milwaukee. “Tightening is in the realm of the theoretical at this point.”

The 10-year note’s yield slid five basis points, or 0.05 percentage point, to 3.12 percent at 4:23 p.m. in New York, according to BGCantor Market Data. The price of the 3.5 percent security maturing in May 2020 gained 14/32, or $4.38 per $1,000 face amount, to 103 7/32.

Policy makers held the target rate for overnight lending between banks at a record low zero to 0.25 percent, a decision forecast by all of the 98 economists in a Bloomberg News survey.

“The economic recovery is proceeding” and “the labor market is improving gradually,” the Federal Open Market Committee said in its statement. Still, “financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad,” the central bank said.

Two-Year Yield

The yield on the two-year note dropped as much as two basis points to 0.66 percent, the lowest level since Dec. 2. It touched the record low of 0.6044 percent on Dec. 17, 2008.

“It’s hard to say if there is a Treasury bubble, because it is hard to say what is an appropriate rate level,” Mueller said. “It depends on how quickly we get out of this. Rates are fairly low.”

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., and Kenneth Volpert, head of taxable fixed-income at Vanguard Group Inc., both said in an interview on CNBC that they don’t think there is a bubble.

Futures on the CME Group Inc. exchange showed an 18 percent chance policy makers will increase the fed funds target by at least a quarter-percentage point by the December 2010 meeting, down from 37 percent odds a month earlier.

“It’s going to be a long, drawn-out process of recovery,” said Richard Schlanger, who helps invest $18 billion in fixed- income securities as vice president at Pioneer Investments in Boston. “Until bank lending expands, the economy is going to be running on quicksand. They’re going to keep the pedal to the metal.”

U.S. Housing Drop

Sales of new homes in the U.S. dropped 32.7 percent in May to a 300,000 annual pace after a tax credit expired, the Commerce Department reported today in Washington. The median forecast of 76 economists in a Bloomberg News survey was for an 18.7 percent decrease.

“That was one ugly home sales release,” said Guy Lebas, chief fixed-income strategist and economist at Janney Montgomery Scott LLC in Philadelphia. “It’s one more check mark in the negative box.”

The difference in yield between 10- and 2-year notes dropped to 2.45 percentage points, the narrowest level on a closing basis since June 9, on speculation inflation is contained. The spread reached a record high 2.91 percentage points on Feb. 22.

The consumer price index dropped 0.2 percent last month in the biggest decrease since December 2008, following April’s 0.1 percent slide, the Labor Department reported June 17.

Swap Spreads

U.S. swap spreads widened for a second day as corporate bond issuance slowed, reducing demand for hedging.

The difference between the rate to exchange floating- for fixed-interest payments for two years and the comparable- maturity Treasury note yield, known as the swap spread, increased 1.56 basis points to 35.81 basis points. The 10-year spread widened 1.50 basis points, to 5.31 basis points.

Today’s auction of five-year notes drew a yield of 1.995 percent, compared with the average forecast of 1.961 percent in a Bloomberg News survey of 9 of the Fed’s 18 primary dealers. The bid-to-cover ratio, which gauges demand by comparing total bids with the amount of securities offered, was 2.58, compared with an average of 2.65 for the previous 10 sales.

Indirect bidders, an investor class that includes foreign central banks, purchased 34.6 percent of the notes, the lowest level since April 2009.

‘Repriced’ Market

“It was surprising,” said Christopher Bury, co-head of fixed-income rates in New York at Jefferies Group Inc., which as a primary dealer is obligated to participate in government auctions. “We’re still at an all-time low in yields, and it sounds like there were a few key investors who stayed away. The market immediately got repriced.”

Yesterday’s sale of $40 billion in two-year notes produced a record low yield of 0.738 percent. The U.S. is scheduled to auction $30 billion of seven-year notes tomorrow.

At the last Federal Open Market Committee meeting in April, some policy makers saw inflation risks as “tilted to the downside in the near term” because of slack in the economy and the chance price expectations may decline. Other officials said inflation may pick up because of an expanding global economy and U.S. budget deficits.

Treasuries declined that day as the refuge appeal of government securities faded and the U.S. sold $42 billion of five-year notes.

To contact the reporters on this story: Cordell Eddings in New York at ceddings@bloomberg.net; Susanne Walker in New York at swalker33@bloomberg.net

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