Vigilantes Sidelined as Growth Tops Deficit Among Treasury Swap Investors
The worst performance by Treasuries since the second quarter of 2009 reflects prospects for faster U.S. economic growth rather than concern that rising budget deficits will drive investors away from government debt.
While the average yield on Treasuries rose to 1.89 percent from 1.42 percent at the end of September, according to the Bank of America Merrill Lynch Treasury Master index, the price of credit-default swaps tied to U.S. debt declined to 41.5 basis points from 48.4 basis points at the end of September, Bloomberg data showed. The dollar rose 1.5 percent against an index of currencies of six major U.S. trading partners.
The drop in swap prices and the greenback’s strength shows bond vigilantes aren’t ready to punish the U.S. for its spending. Pacific Investment Management Co. and JPMorgan Chase & Co. raised their growth forecasts after President Barack Obama agreed to extend George W. Bush-era tax cuts as reports show gains in retail sales, manufacturing and consumer confidence.
“More than anything else, it’s a growth story,” said Charles Comiskey, head of Treasury trading at Bank of Nova Scotia in New York. “From the fiscal stimulus to the monetary stimulus to the tax extensions, it’s the belief that the U.S. government is all in.”
The Obama administration’s 2011 budget forecast a $1.267 trillion deficit for the fiscal year, which ends Sept. 30, after shortfalls of $1.294 trillion in fiscal 2010 and $1.416 trillion in the 2009 fiscal year.
Even as deficits remain at almost record highs, the bond market is giving the U.S. time to address structural budget imbalances. A Bloomberg News survey of the 18 bond dealers that serve as counterparties to the Federal Reserve in its open market transactions show they forecast the 10-year Treasury yield to rise to 3.65 percent from 3.30 percent on Dec. 31, below its average of 4.33 percent since 2000. Two-year yields will climb to 1.05 percent from 0.59 percent, holding below the average of 3.03 percent since the beginning of 2000.
Bond dealers and foreign and domestic investors bid about $494 billion for $165 billion of Treasury securities auctioned during December, government data show. That’s an almost 3-to-1 bid-to-cover ratio, matching the demand for Treasuries during 2010.
“If there were some new concern about the U.S. budget situation it would have shown up in the currency markets, which it hasn’t,” said Tony Crescenzi, a portfolio manager and strategist at Pimco in Newport Beach, California, which runs the world’s biggest bond fund.
The dollar strengthened 0.4 percent during the quarter, as measured by IntercontinentalExchange Inc.’s dollar index, and gained 1.5 percent for the year after a 4.2 percent decline in 2009. The index rose 0.4 percent today.
Pimco’s forecast is for 3.5 percent economic growth in the fourth quarter of 2011 from the year-earlier period, up from 2.5 percent. JPMorgan, the second-biggest U.S. bank by assets, boosted its 2011 growth forecast half a percentage point to 3.1 percent.
Ten-year Treasury note yields rose 78 basis points to 3.29 percent during the fourth quarter, as prices tumbled. Treasuries handed investors a loss of 2.67 percent in the period, according to Bank of America Merrill Lynch data, the worst performance since the second quarter of 2009, following the start of the Fed’s first round of Treasury purchases, when investors saw a 3.08 percent loss.
“The move up in yields is associated with an improved outlook, improved data,” Crescenzi said in a telephone interview. “Global investors have kicked their concerns about the budget situation down the road. There’s no urgency to moving on the deficit, so there’s no reason to be selling the dollar.”
Reports last week from the government and private groups showed U.S. economic growth is quickening. Jobless claims fell by 34,000 to 388,000, breaking the 400,000 level for the first time since July 2008, the Labor Department said Dec. 30. The Institute for Supply Management-Chicago Inc. said its business barometer rose to 68.6 in December, the highest since 1988.
Sales at U.S. retailers advanced 5.5 percent during the holiday season, the best performance in five years, said MasterCard Advisors’ SpendingPulse. The U.S. added jobs in December for a third month, economists said before a Labor Department report Jan 7.
Even as the economic outlook has improved, the pace of consumer price increases remained lower than monetary policy makers’ long-term goal, tempering the drop in bond prices. The Fed’s preferred price gauge, personal consumption excluding food and energy costs, rose at a record-low 0.5 percent annual pace in the third quarter, the Commerce Department said Dec. 22.
“There’s no risk currently of a resurgence of inflation,” said Christopher Sullivan, who oversees $1.7 billion as chief investment officer at United Nations Federal Credit Union in New York. “That should restrain the bond vigilantes desire to push yields up aggressively. Yields need to normalize as the economy gradually improves. We should see that in the coming quarters, but it should be fairly gradual.”
Economist Ed Yardeni coined the term “bond vigilantes” in 1983 for investors who protest inflationary monetary or fiscal policies by selling bonds and driving up government borrowing costs. Their greatest claim to victory was the 1993 decision by President Bill Clinton to abandon plans for an economic stimulus package on the advice of Robert Rubin, then an administration economic adviser, who said it would reduce demand for Treasuries, leading to increased borrowing costs.
Since the end of the Clinton Administration in January 2001, outstanding marketable Treasury debt has almost tripled to $8.75 trillion from $2.98 trillion. Most of the increase in borrowing has come since the start of the financial crisis in July 2007, when outstanding tradable U.S. government securities totaled $4.4 trillion.
“The budget situation is serious,” said Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch in New York, one of the 18 primary dealers. “You’re seeing it in the steepening of the yield curve. You should be paid more to take each additional year of U.S. credit risk.”
The gap between two- and 10-year Treasury yields, known as the yield curve, has widened to 2.70 percentage points from 2.08 percentage points at the end of September, about the lowest since April 2009.
The tax-cut agreement between Obama and Republicans in Congress brings budget concern much closer to the point where it will become pressing, Misra said. “It seems there’s no political will to control the deficit,” she said.
Credit default swaps on Treasuries show that the deficit isn’t an immediate concern for investors.
At 41.5 basis points, the cost of insuring against a default by the U.S. is at its average for 2010, and is down from a peak of 63.28 basis points in February after Moody’s Investors Service said that the country’s Aaa bond rating “could come under downward pressure.”
The current prices of the swaps means investors are paying $41,450 a year for five years to protect $10 million of debt.
Germany CDS prices have risen to 58.7 basis points, the highest since May, when the euro plunged on concerns the Greece financial crisis would spread through Europe, from 38.96 basis points at the end of September. The price to protect U.K. gilts from default also increased in the fourth quarter, to 73.94 basis points from 65 basis points in the previous period.
Growth stemming from the tax cuts and stimulus spending will help the deficit once it takes root in the economy, according to John Briggs, a U.S. government bond strategist at RBS Securities Inc. in Stamford, Connecticut, a primary dealer.
Stocks, Junk Bonds
“The deficit part is more gray, because if you have stronger growth you have better receipts, so you can’t just mechanically adjust up your forecast for issuance,” Briggs said.
At the same time Treasuries fell, the Standard & Poor’s 500 Stock Index surged 10.2 percent last quarter and high-yield, high-risk corporate bonds returned 3.07 percent, according to the Bank of America Merrill Lynch High Yield Master II index.
Gains in stocks and junk bonds reflect optimism that the Fed and Chairman Ben S. Bernanke will avoid deflation by purchasing $600 billion of Treasuries in a policy known as quantitative easing, or QE.
“The market is starting to believe the Fed will be successful in creating growth,” said Ray Humphrey, who manages inflation-indexed bond portfolios in Hartford, Connecticut for Hartford Investment Management Co., which has $161.7 billion in assets. “Nominal bonds are frankly reflecting those higher growth rates.”
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