Bond Bears Collide With Swaps Showing Low Rates

Just the hint the Federal Reserve would end debt purchases that have supported bond prices sent Treasury yields soaring last month to the highest since April, a reaction that is unwarranted if money markets are a guide.

Even as yields rose, overnight index swaps that traders use to speculate on the path of the Fed’s target interest rate for overnight loans between banks signaled that the zero to 0.25 percent range won’t increase for more than two years. In a bullish sign for bonds, Bank of America Merrill Lynch’s MOVE Index, which tracks the outlook for swings in U.S. government debt rates, shows investors don’t anticipate an increase in price swings.

While investors dumped bonds as minutes of recent Fed meetings showed central bankers raised doubts about whether they need to keep buying $85 billion of debt securities a month to support the economy, the bigger influence on Treasuries is what policy makers say about the path of rates, JPMorgan Chase & Co. data show. Bonds rallied the most last week since August as Fed Chairman Ben S. Bernanke told Congress that it would take a “substantial improvement” in employment to end the purchases.

“The Fed has been very articulate about the direction of short-term rates,” said Krishna Memani, the chief investment officer of fixed-income in New York at OppenheimerFunds Inc., which oversees $80.7 billion. “It is entirely data-driven and nobody expects that data to improve” enough to satisfy the Fed “anytime soon,” he said in a Feb. 27 telephone interview.

Bond Rebound

Yields on 10-year notes fell 12 basis points, or 0.12 percentage point, to 1.84 percent last week, the biggest decline since the period ended Aug. 31, according to Bloomberg Bond Trader data. The price of the benchmark 2 percent note due in February 2023 rose 1 3/32, or $10.94 per $1,000 face amount, to 101 13/32. Memani said he see yields ranging from 1.8 percent to 2.25 percent this year. The yield was unchanged at 8:07 a.m. in New York.

Last week’s rally came after yields increased to about an eight-month high of 1.97 percent on Jan. 4, the day after minutes of the December 11-12 Federal Open Market Committee meeting showed policy makers questioned whether the more than $2.3 trillion of monetary easing since 2008 risked unleashing inflation and fueling an asset-price bubble.

Yields continued to rise, reaching a high of 2.05 percent on Feb. 20 after minutes from January’s FOMC meeting showed policy makers discussed slowing or ending purchases of mortgage and Treasury debt.

Bernanke Testimony

Bernanke told Congress last week in Washington that the central bank was maintaining its guidance that rates are likely to remain at record lows. There’s no evidence that the Fed’s unprecedented asset purchases risked sparking inflation or creating price bubbles, he said.

It’s the FOMC’s “intention to maintain accommodation as long as needed to promote a stronger economic recovery with stable prices,” Bernanke told the Senate Banking Committee Feb. 26 in Washington. “Since longer-term interest rates reflect market expectations for shorter-term rates over time, our guidance influences longer-term rates and thus supports a stronger recovery.”

The Fed’s bond purchases, a policy of known as quantitative easing, or QE, may not be the most important influence for yields. JPMorgan data shows that the end of QE would trigger only about an 8 basis-point rise in 10-year note yields, while the Fed’s plan to keep rates at zero into 2015 is keeping them about 40 basis points below where they’d be otherwise.

Inflation Slowdown

Record low rates since December 2008 have kept borrowing costs in check for everything from car loans to mortgages, while fostering an economic recovery that still isn’t assured. The unemployment is more than a percentage point above the Fed’s 6.5 percent goal and its preferred inflation gauge, the personal consumption expenditures index, rose 1.3 percent in January from a year earlier, the smallest increase since April 2011.

“Premature rate increases would carry a high risk of short-circuiting the recovery, possibly leading -- ironically enough -- to even longer period of low long-term rates,” Bernanke said in a March 1 speech in San Francisco.

Implied forward rates for contracts that show what traders expect the federal funds effective rate to average over a set time period in the future indicate that a quarter-percentage point increase won’t come until about the middle of 2015. The pricing in overnight index swaps of the Fed’s first rate increase has generally mirrored the Fed’s guidance over the past year.

‘Huge Losses’

The MOVE Index, which measures volatility based on prices of over-the-counter options on Treasuries maturing in two to 30 years, ended last week at 55. While that’s up from a record low of 51 on Dec. 3, it’s down from a post-financial crisis peak of 264.6 on Oct. 10, 2008 and below the average of about 100 since the beginning of 2000.

“The Fed’s debt purchases are helpful on the margin, but to a lot of people in the bond market the rate guidance is more important,” James Evans, a senior vice president at New York-based Brown Brothers Harriman & Co. who helps oversee $15 billion in fixed-income assets, said in a March 1 telephone interview. “That’s more so what’s keeping Treasury yields low.”

Not everyone agrees. Michael Schumacher, the head of global-rates strategy at UBS AG, says investors will face “huge losses” from a “big jolt” in yields when the Fed reduces its support. UBS is one of the 21 primary dealers of U.S. government securities that trade with the Fed and are obligated to bid at the Treasury’s debt auctions.

Fed’s Assets

The central bank’s balance sheet swelled to more than $3 trillion as of Feb. 21, including $1.74 trillion of Treasuries securities, $74.6 billion of Federal agency bonds and $1.03 trillion of mortgage-backed debt, central bank data show.

Investors should buy five-year Treasuries and avoid longer-term bonds, which would lose the most value when all the new money created by the Fed begins to spark inflation, Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., wrote on Twitter Feb. 8.

Asset-price “irrationality” is rising after years of record low Fed rates, he wrote on Feb. 27 in his monthly investment outlook posted on Newport Beach, California-based Pimco’s website.

Instead of raising their yield forecasts, economists and strategists have steadily lowered them over time. The median of or more than 50 estimates in a Bloomberg survey is for 10-year yields to trade at 2.25 percent at year-end, lower than the 3 percent that was predicted in April 2012.

Losses Trimmed

Last week’s rally helped Treasuries trim losses for the year to 0.23 percent from as much as 1.13 percent on Feb. 13, according to Bank of America Merrill Lynch’s U.S. Treasury Index. U.S. government debt returned 2.16 percent in 2012, including reinvested interest.

Hedge funds and other large speculators raised their bets that 10-year Treasuries will rally to the most this year. The difference in the number of bets on a gain and those on a decline rose to 115,908 contracts as of Feb. 26, according to U.S. Commodity Futures Trading Commission data.

Tax increases that went into effect Jan. 1 and $85 billion of government budget cuts means the economy will probably slow this year. Gross domestic product may expand 1.8 percent in 2013, down from 2.2 percent in 2012, according to the median estimate of more than 75 economists surveyed by Bloomberg.

“The Fed is not going to stop buying bonds anytime soon because the economy is just not there yet, it hasn’t reached escape velocity,” Richard Gordon, a fixed-income market strategist at Wells Fargo & Co. in Charlotte, North Carolina, said in a Feb. 28 interview. “We just don’t have any real inflationary pressures.”

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