Treasuries Drop as Unemployment Rate Unexpectedly Falls

Treasuries fell for the first time in three weeks after a report showing the U.S. unemployment rate unexpectedly declined renewed concern the Federal Reserve’s commitment to strengthen the economy may stoke inflation.

The yield on the 10-year note rose to the highest in almost two weeks after the Labor Department said yesterday that the jobless rate dropped to 7.8 percent in September, the lowest since President Barack Obama took office in January 2009. The difference in yields between 10-year notes and inflation-protected debt increased to the most in almost three weeks. The U.S. will sell $66 billion in notes and bonds next week.

“It’s potentially the end of the ridiculously low yields for the bond market,” said William Larkin, a fixed-income money manager who helps oversee $500 million at Cabot Money Management Inc. in Salem, Massachusetts. “The trend is going higher. We’ve been getting better economic data even though it’s not as robust as the market would like.”

The benchmark 10-year note’s yield rose 11 basis points, or 0.11 percentage point, to 1.75 percent last week, according to Bloomberg Bond Trader data. That’s the highest since Sept. 24. The 1.625 percent security due August 2022 slipped 31/32, or $9.69 per $1,000 face amount, to 98 29/32.

The gap in yields between 10-year notes and 30-year bonds increased to 1.23 percentage points, or 123 basis points, the most since September 2011, as investors demanded a bigger premium against the risk of inflation. The longer the maturity of a security, the more its fixed payments are at risk of being eroded over time.

Value Measure

“The bear steepening we saw today was consistent with a

slightly better economic picture in the context of very easy

monetary policy,” said Eric Stein, a money manager in Boston at Eaton Vance Management, which oversees $203TK billion.

Treasuries yesterday traded at the least expensive level in two weeks. The 10-year term premium, a model created by economists at the Fed that includes expectations for interest rates, growth and inflation, was negative 0.88 percent. It reached negative 0.97 percent on Sept. 26, the most costly since July 25. A negative reading indicates investors are willing to accept yields below what’s considered fair value. The average for 2012 is negative 0.75 percent.

Ten-year yields will rise to 1.75 percent by December, according to the median forecast in Bloomberg surveys of banks and securities firms.

Speculative Positions

Even so, hedge-fund managers and other large speculators increased bets the 10-year note will continue to rally in the five days ended Oct. 2, according to U.S. Commodity Futures Trading Commission data. Speculative long positions, or bets prices will rise, outnumbered short positions by 161,790 contracts on the Chicago Board of Trade. Net-long positions rose by 78,264 contracts, or 94 percent, from a week earlier.

The unemployment rate fell from 8.1 percent in August as employers took on more part-time workers as the economy added 114,000 positions in September. The jobless rate was forecast to rise to 8.2 percent, according to the median estimate of 88 economists surveyed by Bloomberg. The median estimate for job gains was 115,000, according to another survey.

The so-called break-even rate, which measures how much traders anticipate consumer prices will rise over the life of the debt, for 10-year securities yesterday touched 2.62 percentage points, the highest since Sept. 17.

Presidential Election

“It’s a combination of higher inflation expectations and higher growth expectations,” said Michael Pond, head of global inflation-linked research in New York at Barclays Plc, one of the 21 primary dealers that trade with the Fed.

The payrolls data, the penultimate before the November presidential election, may give Obama a boost after he stumbled in this week’s debate against Republican challenger Mitt Romney. The jobless rate had stayed above 8 percent since February 2009.

“It’s a piece of more optimistic data with regard to the labor market,” said Christopher Sullivan, who oversees $2 billion as chief investment officer at United Nations Federal Credit Union in New York.

The Fed signaled it’s moving toward linking its outlook for near-zero interest rates to specific economic conditions such as a decline in the unemployment rate.

Policy makers including Charles Evans, the president of the Chicago Fed, have said the central bank should promise to keep rates low until the unemployment rate falls to 7 percent, so long as inflation does not breach 3 percent. In minutes from their most recent meeting released Oct. 4, participants said such a strategy would give the Fed more flexibility to adjust to changing economic conditions, while saying it would be “challenging” to agree on specific thresholds, given a diversity of views.

Interest Expense

Policy makers last month also said they could change the size of the central bank’s monthly asset purchases to reduce the risks associated with the program, such as disrupting financial markets and spurring inflation, the minutes showed.

The central bank bought $2.3 trillion of Treasury and mortgage-related debt from 2008 to 2011 in two rounds of purchases, known as quantitative easing. It also began its Operation Twist program to replace shorter-term debt in its portfolio with longer-term securities and put downward pressure on long-term borrowing costs.

The U.S. will auction $32 billion in three-year debt, $21 billion in 10-year securities and $13 billion in 30-year bonds on three consecutive days starting Oct. 9.

The U.S. government’s interest expense fell to the lowest in seven years as yields on Treasury debt dropped to records even as debt soared beyond $16 trillion for the first time, aided by a one-time accounting change.

The U.S. paid $359.8 billion in interest on $16.1 trillion of debt in the 12 months ended Sept. 30, according to Treasury Department data. That’s down from $454.4 billion for the 2011 fiscal year and the least since $352.4 billion in fiscal 2005.

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