Bernanke Sedates Bond Traders Seeing Treasuries Added to QE3
The world’s biggest bond traders say the Federal Reserve will decide before year-end to buy Treasuries in addition to purchasing $40 billion of mortgage bonds a month as gains in U.S. employment and consumer confidence prove unsustainable.
All 21 primary dealers that trade with the central bank expect its latest quantitative-easing measures to be expanded to include government securities, according to a survey last week by Bloomberg News. Rather than increasing on speculation the central bank’s latest measures would spur the economy, volatility in the bond market has held at about the lowest since 1988, a sign of continued demand for the safety of Treasuries.
While the unemployment rate fell to 7.8 percent in September, the lowest level since 2009, and consumer confidence climbed to a six-month high, traders are looking ahead to a potential slowdown if Congress fails to avert $607 billion in mandated tax increases and spending cuts starting Dec. 31 and as Europe’s debt crisis drags into a fourth year. Economists at JPMorgan Chase & Co. cut their forecasts on Oct. 18 for U.S. economic growth in the first and second quarters of 2013.
“The Fed has said they are dissatisfied with the pace of the recovery, particularly the improvement of labor-market conditions,” Michael Gapen, director of U.S. economic research at Barclays Plc in New York and a former Fed economist, said in a telephone interview Oct. 17. “They have said they want to do more to generate a stronger recovery and to keep doing more until they get the recovery they want.”
Expectations for more stimulus come with the Fed’s Operation Twist, an exchange of $667 billion in short-term debt for longer-maturity securities to help contain borrowing costs, scheduled to end Dec. 31. When they announced the mortgage buying plan on Sept. 13, policy makers said they would keep pumping money into the economy until there was “ongoing, sustained improvement” in the labor market.
None of the dealers expect the Fed to announce any new program when policy makers meet this week.
While the unemployment rate is below 8 percent for the first time since January 2009, and Commerce Department figures last week showed retail sales grew 1.1 percent in September after rising 1.2 percent in August for the best back-to-back showing since 2010, economists are still seeing weakness.
The unemployment rate is above the average of 5.1 percent from January 2000 to mid-2007.
JPMorgan said the so-called fiscal cliff of tax increases and spending cuts will subtract 1 percentage point from growth, double its previous estimate. The largest U.S. bank by assets sees gross domestic product expanding at a 1 percent annual rate in the first three months of 2013, down from a prior forecast of 1.5 percent. In the second quarter, the economy will grow at a 1.5 percent pace, from 2.25 percent.
Bank of America Corp. predicts the Fed will add $45 billion to $60 billion of Treasuries a month, while Barclays expects the purchases will last until June and total $270 billion. Royal Bank of Canada’s RBC Capital Markets unit forecasts $30 billion in monthly Treasury purchases.
Low yields have cut the government’s cost of financing budget deficits exceeding $1 trillion for four straight years, while lowering corporate and consumer borrowing rates. Yields on company bonds fell to a record 3.58 percent last week, from more than 5.6 percent in early 2010, Bank of America Merrill Lynch index (SPX) data show. Freddie Mac says rates on 30-year mortgages average 3.37 percent, down from 5.21 percent.
Low rates have helped companies refinance debt and bolstered homes sales. Corporate bonds issued globally this year total $3.2 trillion, second only to the $3.32 trillion sold at the same point in 2009, data compiled by Bloomberg show. Sales of previously owned U.S. homes rose in August to the highest level in two years before easing in September, figures from the National Association of Realtors show.
Bernanke said in a speech in August at the Fed Bank of Kansas City’s Economic Symposium in Jackson Hole, Wyoming, that central-bank studies show the cumulative effect of asset purchases have lowered 10-year Treasury yields between 80 and 120 basis points.
The yield on 10-year Treasuries rose three basis points, or 0.03 percentage point, to 1.79 percent at 9:54 a.m. in New York. The price of the benchmark 1.625 percent security due August 2022 fell 7/32, or $2.19 per $1,000 face amount, to 98 17/32.
The rate has fallen from this year’s high of 2.40 percent on March 20, and last year’s high of 3.77 percent in February, showing that signs of growth haven’t been enough to persuade dealers or Bernanke that the economy is back on track.
As well as announcing purchases of mortgage-debt, policy makers said last month they would probably hold the federal funds rate at about zero at least through mid-2015. The Federal Open Market Committee is scheduled to meet Oct. 23-24.
“If we were to see some good news on growth I would not expect policy makers to respond in a hasty manner” and remove stimulus, Fed Bank of New York President William C. Dudley said in a speech in New York Oct. 15.
Volatility would likely increase if traders expected the Fed to stop buying bonds anytime soon. Instead, it has fallen. Bank of America Merrill Lynch’s MOVE Index, which measures volatility based on prices of over-the-counter options on securities maturing in two to 30 years, ended last week at 68.5, down from the year’s high of 95.4 on June 15.
“The defining characteristic of the Treasury market over the next several months will be the low volatility,” Carl Lantz, the New York-based head of interest-rate strategy for Credit Suisse Group AG, said in an Oct. 17 telephone interview.
The company’s economists forecast the Fed will purchase $45 billion a month in Treasuries next year.
GDP will expand at a 2.1 percent annual rate for 2012, according to the median estimate of 99 economists in a Bloomberg survey. Growth averaged 3.1 percent in the three years before the financial crisis hit in 2007 as the Fed raised its benchmark rate to 5.25 percent from 1 percent.
“If economic growth remains near where it is now, it will be difficult for the Fed to make the argument that we’ve had sustained and substantial improvement” when they meet in December, Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch in New York, said in a telephone interview on Oct. 12.
The U.S. economy would slow by as much as 0.5 percent next year if Congress allows the $607 billion in tax increases and budget cuts to go into effect Dec. 31, according to the Congressional Budget Office.
Half the spending decreases are in Defense Department programs. Contractors including Lockheed Martin Corp. and Northrop Grumman Corp. have warned that layoffs may result. Take-home pay will shrink if temporary reductions in payroll taxes are allowed to expire.
“There’s some reluctance to jump into the yields-are- going-higher trade until we have a better sense of how that’s going to play out,” Michael Cloherty, head U.S. interest-rate strategist at RBC Capital Markets in New York, said in an Oct. 15 telephone interview.
President Barack Obama has said he will veto legislation to address the expiration of measures that have held payroll and income taxes down unless it includes higher levies for the wealthiest citizens. Republican challenger Mitt Romney has promised not to reappoint Bernanke when his second four-year term ends January 2014. The presidential election is Nov. 6.
Whoever wins, “it’s certainly possible that in the short term you’d get more fiscal drag, lower yields, a weaker economy,” Jan Hatzius, chief economist at Goldman Sachs Group Inc., said in an interview on Oct. 16. “But in general the pattern in 2013 is likely to be that as you go through the year the economy gets a bit better and yields pick up a bit.”
Banks have boosted loans to companies and equities have rallied. Commercial and industrial lending has climbed 23 percent to $1.48 trillion as of Oct. 10 from $1.2 trillion two years ago, after plunging from $1.6 trillion in October 2008, according to the latest data released by the Fed.
The Standard & Poor’s 500 Index climbed 16 percent this year through Oct. 19 after ending little changed in 2011. The S&P 500 fell 0.1 percent to 1,431.84 at 9:41 a.m. New York time.
Economists also point to turmoil in Europe as weighing on the U.S. A European Union summit last week failed to discuss further financial assistance for Spain, according to French President Francois Hollande.
The International Monetary Fund in Washington said Oct. 9 it sees “alarmingly high” risks of a steeper global slowdown, with a one-in-six chance of growth slipping below 2 percent.
Tame inflation is another reason why bond volatility is low and traders say the Fed has scope to increase stimulus. Inflation as measured by the personal consumption expenditures index, the gauge preferred by the Fed, rose 1.6 percent in August from a year earlier, less than the central bank’s goal of 2 percent.
Fed Bank of Chicago President Charles Evans, who has called for additional monetary stimulus, said last month that policy makers should hold rates about zero until unemployment falls to 7 percent or inflation rises to 3 percent.
“In no uncertain terms, the Fed needs to see much lower unemployment,” Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities in New York, said in an interview Oct. 16. “Treasury yields are going to be capped by the fact that the Fed is going to buy a significant amount.”
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