Treasury Break-Even Rate Rises to 5-Month High on Outlook

The gap between yields on Treasury 10-year notes and inflation-linked securities widened to the most in more than five months amid speculation the Federal Reserve’s efforts to spur the economy will send costs higher.

Thirty-year bond yields reached almost a two-week high as the U.S. prepared to sell $66 billion of bonds and notes this week. The so-called 10-year break-even rate, a gauge of traders’ outlook for inflation, climbed for a fifth day after data last week showed slower job growth, boosting speculation the Fed will increase asset purchases, or quantitative easing, to support the economy. The Federal Open Market Committee meets on Sept. 12-13.

“When you start talking about more QE, the potential for inflation concern down the road increases,” said Jason Rogan, director of U.S. government trading at Guggenheim Partners LLC, a New York-based brokerage for institutional investors. Further quantitative easing is “pretty well priced in,” he said.

The benchmark 10-year yield dropped one basis point, or 0.01 percentage point, to 1.65 percent at 5 p.m. New York time after falling earlier as much as three basis points. The price of the 1.625 percent note due in August 2022 rose 1/8, or $1.25 per $1,000 face amount, to 99 23/32.

Thirty-year yields declined two basis points to 2.81 percent after touching 2.863 percent. They reached 2.864 percent on Sept. 7, the highest level since Aug. 22.

Yield Gap

The yield difference between 10-year notes and similar-maturity Treasury Inflation Protected Securities, which represents traders’ outlook for the rate of inflation over the life of the securities, touched 2.40 percentage points today, the widest since March 22, before slipping to 2.37 percentage points. The average over the past decade is 2.16.

Treasury volume reported by ICAP Plc, the largest inter-dealer broker of U.S. government debt, dropped 45 percent today to $194 billion. It has averaged $239 billion in 2012.

Volatility dropped to 68 basis points, the lowest level since Sept. 4, according to Bank of America Merrill Lynch’s MOVE index. The 2012 average is 74 basis points. The index measures price swings based on options.

The spread between 10- and 30-year yields reached 1.18 percentage points, the most since May on a closing basis. Thirty-year bonds, because of their longer maturity, are more sensitive to inflation than shorter-dated Treasuries.

U.S. payrolls rose by 96,000 in August, below the 130,000 median forecast in a Bloomberg News survey, Labor Department data showed on Sept. 7. The Fed has already purchased $2.3 trillion of Treasury and mortgage-related debt in two QE rounds to spur economic recovery.

‘Weak Number’

“The Fed will do what it thinks it needs to do to support the economy,” Thomas Girard, a senior managing director who oversees $150 billion in fixed income at New York Life Investment Management in New York, said in a telephone interview Sept. 7. “The jobs number was a weak number, and it increases the likelihood that the Fed does something.”

The central bank’s favored bond-market gauge of inflation expectations, the five-year, five-year forward break-even rate, was 2.48 percent on Sept. 5, versus the 2012 average of 2.54 percent. The measure shows how much traders anticipate consumer prices will rise during a period of five years starting in 2017.

“Entering a possible third round of QE, a bear steepener is an understandable reaction, but that doesn’t necessarily make it the right one,” Jim Vogel, head of agency-debt research at FTN Financial in Memphis, Tennessee, said in a telephone interview. “We’re still in a short-term self-correcting phase where any realized inflation would burn itself out in the next two to three years because the economy isn’t healthy enough.” In a bear steepener, longer-maturity yields rise at a faster pace than shorter-term yields.

Fed Purchase

The Fed bought $1.35 billion of TIPS today as part of a program to swap shorter-term Treasuries in its holdings with those due in 6 to 30 years to put downward pressure on long-term borrowing costs. It purchased securities due from January 2019 to February 2042.

The Treasury will auction $32 billion in three-year debt tomorrow, $21 billion in 10-year securities Sept. 12 and $13 billion in 30-year bonds the next day.

“The market is nervous about taking down supply in this environment,” said Thomas Roth, senior Treasury trader in New York at Mitsubishi UFJ Securities USA Inc.

The U.S. sold $32 billion of three-year notes at the last offering, on Aug. 7, drawing a yield of 0.37 percent. The record low three-year auction yield was 0.334 percent in September 2011.

Auction Demand

The August auction’s bid-to-cover ratio, which gauges demand by comparing total bids with the amount of securities offered, was 3.51, matching the average for the past 10 sales. Indirect bidders, an investor class that includes foreign central banks, purchased 29.7 percent of the notes, compared with an average of 34.1 percent for the past 10 offerings.

Just six months ago, money market traders expected the Fed to raise interest rates by the end of 2013. Now, they see borrowing costs staying at record lows for about three more years as the economic outlook worsens.

Bond market measures from overnight index swaps, which indicate no rise in the federal funds rate until mid-2015, to a 62 percent decline in a measure of volatility in government bonds signal that rates will stay near zero for longer. The gap between two- and five-year Treasury yields, which decreases when traders expect benchmark rates to remain subdued, is more than 50 percent narrower than its average since 2008.

While the economy expanded in the second quarter, the unemployment rate remained above 8 percent for the 43rd-straight month in August.

‘Prolonged Period’

“The problems have been bigger than anticipated and it will take a while to work our way through these issues,” Larry Dyer, a U.S. interest-rate strategist in New York with HSBC Holdings Plc’s securities unit, said in an interview on Sept. 6. “The bond market is pricing in pretty close to a very prolonged period of low growth,” said Dyer, whose firm is one of the 21 primary dealers that trade with the central bank.

Treasuries have trailed behind stocks this year even as global economic growth slowed. Investors in U.S. government securities earned 2.1 percent in 2012 as of Sept. 7, a Bank of America Merrill Lynch index shows. The Standard & Poor’s 500 Index returned 16 percent, including reinvested dividends.

(Corrects record-low auction yield in 17th paragraph.)
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