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U.S. Yields Price In QE3 as Traders Anticipate $500 Billion

U.S. Federal Reserve Chairman Ben S. Bernanke
U.S. Federal Reserve chairman Ben S. Bernanke. Photographer: Andrew Harrer/Bloomberg

Record-low yields on U.S. Treasuries show traders expect Federal Reserve Chairman Ben S. Bernanke to signal as soon as this week that the central bank will begin a third round of asset purchases to boost the economy, a scenario the world’s biggest bond dealers said is unlikely.

Barclays Plc said 10-year yields indicate traders have priced in $500 billion to $600 billion of Treasury purchases by the Fed. Citigroup Inc. said current rates can only be justified by more central bank bond buying or assuming the economy will shrink by 2 percent.

“The market is pricing in another round of large-scale asset purchases, looking for confirmation possibly as early as the Jackson Hole symposium” in Wyoming this week, Anshul Pradhan, a fixed-income research analyst at Barclays in New York, said in an interview last week. “The probability of that is low. If the Chairman does disappoint, then there should be a reversal in the outperformance of 10-year notes.”

Central bankers from around the world will meet in Jackson Hole at an annual conference sponsored by the Federal Reserve Bank of Kansas City, the same place where Bernanke triggered financial rallies a year ago when he said the Fed was prepared to “do all that it can” to ensure economic recovery and suggested it would purchase more securities if growth slowed.

Fed Dissension

Unlike then, when the Fed’s concern was deflation, investors anticipate faster inflation. In addition, a year ago Bernanke had the full backing of his board. Now, there is more dissension among policy makers than at any time since 1992.

The pressure is on the Fed as manufacturing weakens, consumer confidence tumbles and the unemployment rate holds above 9 percent. Citigroup and JPMorgan Chase & Co., who along with Barclays are among the 20 primary dealers of U.S. government debt that trade directly with the central bank, are cutting their forecasts for U.S. growth.

Slower expansion is translating into the best year for Treasuries since 2008, with gains of 7.67 percent through last week, Bank of America Merrill Lynch indexes show. That compares with 3.45 percent for the rest of the world’s sovereign debt market, based on the firm’s indexes.

The yield on the benchmark 10-year Treasury note, which helps set rates on everything from mortgages to company bonds, ended at 2.07 percent on Aug. 19, down from the high this year of 3.77 percent on Feb. 9. Ten-year notes yielded 2.11 percent as of 8:58 a.m. in New York.

Seeking Refuge

Gains accelerated following the first downgrade of the U.S. credit rating to AA+ from AAA by Standard & Poor’s on Aug. 5. Moody’s Investors Service and Fitch Ratings confirmed their AAA grades. Ten-year yields fell 19 basis points, or 0.19 percentage point last week to 2.07 percent. Yields fell as low as 1.97 percent on Aug. 18, a record, as investors sought a refuge from a plunge in stock markets around the world.

For all the gloom, there are glimmers of strength in the economy that may keep yields from falling further and dissuade the Fed from buying more bonds. Reports the last two weeks showed retail sales climbed in July by the most in four months and consumer prices jumped the most since March.

Barclays expects 10-year yields will end the quarter at 2.9 percent. Goldman Sachs Group Inc., whose economists are the top-ranked forecasters of the security as measured by data compiled by Bloomberg News, revised its year-end estimate last week to 2.75 percent from 3.75 percent.

Cutting Estimates

Treasuries rallied as investors fled higher-risk assets while stock markets tumbled, Europe’s sovereign-debt crisis worsened and economists cut growth estimates. Morgan Stanley, another primary dealer, lowered its forecast for global economic expansion this year to 3.9 percent from 4.2 percent, citing insufficient policy response in Europe’s debt crisis and weakening consumer confidence.

“Yields are justifiable here,” Eric Pellicciaro, head of global rates investment at New York-based BlackRock Inc., which manages $1.14 trillion in fixed-income assets, said in an interview last week. “Things are still incredibly fluid and investor confidence is still very weak. Given what needs to be done in Europe and what it’s going to take to reinstall confidence in the U.S., any rise toward 2.5 percent we see as a buying opportunity,” he said in reference to 10-year yields.

A financial model created by economists at the Fed that includes expectations for interest rates, growth and inflation indicates 10-year notes are the most overvalued on record. The term premium, which Bernanke cited in a 2006 speech in New York as a useful guide in setting monetary policy, fell to negative 0.52 percent last week. The gauge averaged a positive 0.84 percent this decade through mid-2007.

Reversing Course

The last two times the measure came close to this level, in December 2008 and November 2010, yields reversed course and started to rise, producing a loss of 3.08 percent for investors in the first quarter of 2009 and 2.67 percent in the fourth quarter of 2010, Bank of America Merrill Lynch indexes show.

Even if yields were to rise to the 2.82 percent median year-end estimate of more than 50 economists and strategists surveyed by Bloomberg, they would be more than two percentage points below the 5.13 percent average of the past two decades. Low rates are helping the government service a budget deficit that will exceed $1 trillion for a third straight year, even as the amount of marketable debt outstanding soars to $9.4 trillion from $4.3 trillion in mid-2007.

Bernanke told Congress on July 13 that the Fed must “keep all the options on the table” if the economy appeared in danger of stalling or if the threat of deflation looked like it was going to re-emerge.

Fed’s ‘Test’

The Fed bought about $1.7 trillion of government and mortgage related debt in its first round of quantitative easing, or QE1, between December 2008 and March 2010, and purchased $600 billion of Treasuries between November 2010 and June through QE2.

“The market will test the Fed’s resolve” by driving longer-term yields higher, Stuart Thomson, who helps oversee about $120 billion as a money manager at Ignis Asset Management in Glasgow, said in interview last week. He said 30-year Treasuries would look attractive if yields, which were 3.39 percent today, rose to 4 percent.

Since 1978, the Fed Bank of Kansas City has brought together central bankers, finance ministers, economists and academics from around the globe for their annual economic symposium, held now in Jackson Hole. The attendees discuss economic issues and policy options.

Fed Options

Besides purchasing bonds, Bernanke told Congress last month that the Fed could extend the maturity of its debt holdings by reinvesting proceeds of Treasury and mortgage bond redemptions into longer-term debt. It could also spur banks to lend by reducing the rate it pays on their reserves, or give explicit guidance about how long it would keep the federal funds rate or size of its $2.86 trillion balance sheet at current levels.

Unlike a year ago, Bernanke is facing more dissension among policy makers about undertaking additional monetary stimulus. Charles Plosser, president of the Federal Reserve Bank of Philadelphia, Richard Fisher of Dallas and Narayana Kocherlakota of Minneapolis opposed the Fed’s commitment on Aug. 9 to hold its rate at a record low until mid-2013. The last time three policy makers dissented was in November 1992.

“Inappropriate Policy”

“It was inappropriate policy at an inappropriate time,” Plosser, 62, said on Aug. 17 in a radio interview on “Bloomberg Surveillance” with Tom Keene and Ken Prewitt. He said that it wasn’t clear that the economy needed additional stimulus, especially given accelerating inflation and a decline in the unemployment rate since November to 9.1 percent.

The Fed may have fewer options than last year, when inflation was slowing, raising the threat of deflation.

The consumer-price index increased 0.5 percent in July from June, more than twice the 0.2 percent median forecast of economists surveyed by Bloomberg News, figures from the Labor Department showed on Aug. 18. The index climbed 3.6 percent from a year earlier, the most since October 2008.

A measure of traders’ inflation expectations that the Fed uses to help determine monetary policy is 2.99 percent, up from 2.18 percent a year ago. The five-year, five-year forward breakeven rate, which projects the pace of price increases starting in 2016, has averaged 2.8 percent the past five years.

Inflation Expectations

Yields on Treasury Inflation-Protected Securities, or TIPS, show traders expect inflation during the next 10 years will be about 0.5 percentage point higher than they forecast a year ago. The breakeven inflation rate, calculated from yield differences on 10-year Treasury notes and inflation-indexed U.S. government bonds of similar maturity, has risen to 2.01 percent from a nine-month low of 1.47 percent reached on Aug. 25, 2010.

By driving yields down, bond traders may already be accomplishing their own version of QE3.

“While Mr. Bernanke will keep his options open going forward, people in the bond market looking for an early move to QE3 will be disappointed,” Neil Mackinnon, an economist at VTB Capital in London and a former U.K. Treasury official, said in an interview last week. “The Fed through explicit guidance has so far worked in terms of bringing the curve and rates down. Also cash is king now and there is a flight to safe, quality collateral which is bringing down bond yields anyway. This helps the Fed.”

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