Volatility Calmed Amid Worst Loss for Treasuries Since 2010

The biggest losses for Treasuries in more than two years and disunity among Federal Reserve officials over the pace of economic stimulus are doing little to rattle investors calmed by slowing inflation and too-high unemployment.

U.S. government bonds lost 1.27 percent including interest this month, the most since December 2010, according to Bank of America Merrill Lynch’s U.S. Treasury Index. At the same time, investor expectations for inflation have fallen, bond strategists are cutting year-end forecasts for 10-year yields, and options on interest-rate swaps show projected price swings just above the six-year low reached in April.

Unemployment at 7.5 percent, estimates for the narrowest budget deficit since 2008 and a 1.1 percent inflation rate are keeping yields and volatility contained even as investors fret while Fed Chairman Ben S. Bernanke and some of his colleagues disagree about when to curtail the central bank’s $85 billion a month of bond purchases. President Barack Obama needs low rates to stimulate an economy forecast to grow 2 percent this year, below the average of 2.5 percent for the past two decades.

“We expect things to continue to go sideways for the next couple of months with less volatility than you’ve seen this month,” Gary Droscoski, a fixed-income money manager in New York for GAM USA, which oversees $16 billion, said in a telephone interview on May 22. “We really don’t buy into this more-recent talk about re-pricing in the bond market.”

Yields Rise

While yields on 10-year bonds rose above 2 percent last week for the first time since March, 75 strategists surveyed by Bloomberg cut their median forecasts for year-end rates to 2.15 percent from 2.25 percent in April. Treasury Inflation-Protected Securities show investors anticipate an average increase of 2.26 percent in consumer prices for the next decade, down from the 2.64 percent estimated in September.

Remarks from policy makers show the central bank has yet to reach consensus on when or how to dial back the bond-purchase program designed to spur growth and reduce unemployment.

Philadelphia Fed President Charles Plosser has called for reducing stimulus at the Fed’s next meeting in June, while Bernanke and Federal Reserve Bank of New York President William C. Dudley have stressed that a premature exit risks hampering growth and roiling investors.

Bernanke’s Testimony

“A big market correction” was a probable outcome if the Fed moved “very quickly and unexpectedly” to tighten monetary policy, Bernanke said last week in response to a question following testimony to Congress.

The asset-purchase programs, known as quantitative easing, or QE, which began in 2008, have lifted the central bank’s assets to $3.4 trillion from below $1 trillion five years ago.

Treasury 10-year note yields rose in each of the past four weeks, the longest stretch since the period ended Aug. 17, to 2.01 percent as of May 24. The price of the benchmark 1.75 percent note due May 2023 fell 1/2, or $5 per $1,000 face value, to 97 21/32. Treasuries were closed yesterday for Memorial Day.

Should yields rise as predicted by forecasters, holders will incur losses. An investor buying $10 million in 10-year bonds at last week’s yield would lose $49,000 if it rose to 2.2 percent by the end of this year.

The rate climbed to 2.04 percent today at 7:37 a.m. in New York.

Even as owners of long-term Treasuries lost money this month, forward markets suggest the 10-year yield will stay below 3 percent until at least 2017. That’s beyond the point when most primary dealers expect debt purchases to end and for the Fed to start raising its target rate for overnight loans between banks from the zero to 0.25 percent that’s been in effect since December 2008.

Dealer Forecasts

The 21 primary dealers that trade securities directly with the Fed forecast last month that the central bank’s quantitative easing program will end in the second quarter of 2014, with the majority predicting the first rate increase in 2015.

One measure of projected yield swings, normalized volatility on one-year options for 10-year U.S. interest-rate swaps, or 1y10y swaptions, touched 71.8 basis points on April 30, the lowest since June 2007. While it rose as high as 82.5 last week, it’s below the 111 over the past five years.

Bank of America Merrill Lynch’s MOVE Index, which tracks option projections for the pace of swings in Treasuries maturing in two to 30 years, fell to a record 48.87 on May 9. The index rose to as high as 68.2 last week, below the average of 96.6 since 2006.

‘Methodical’ Fed

“There are a lot of players in the market that are itching to play a QE exit story,” Thomas Graff, who manages $3.6 billion of fixed-income assets at Brown Advisory Inc. in Baltimore, said in a May 21 telephone interview. “People are anxious to do that trade, to their detriment. The Fed is a lot more methodical, a lot more deliberate than traders give them credit for.”

Treasuries are also being supported by foreign holdings, which rose 0.7 percent to $5.76 trillion in March. Overseas investors owned 50.5 percent of the $11.4 trillion in U.S. debt outstanding in March.

Foreign central banks accounted for $2.963 trillion of U.S. government debt held in custody at the Fed on May 22, up from $2.609 trillion at the end of 2011, government data showed.

“Chairman Bernanke looks powerful now but that’s because global investors believe his forecast and the whole world has been betting with him,” Joe Ramos, a fixed-income portfolio manager at Lazard Asset Management, said during an interview at the firm’s office at 30 Rockefeller Plaza on May 20.

Tightening Signal

“If the Fed signals it is stopping purchases, it would likely signal to investors that health is returning to the underlying economy and that would naturally lead to higher interest rates,” said Ramos, whose firm oversees $155.7 billion, with about 10 percent in fixed-income assets. He forecasts the 10-year yield to gradually move to 3 percent after the Fed begins to scale back debt purchases.

Indications that some regional Fed presidents want to start paring the purchases as soon as next month if data continues to show the expansion gaining strength conflict with Bernanke’s comments to Congress last week that the economy remains hampered by high unemployment and government spending cuts, so tightening policy too soon would endanger the recovery.

The Fed has pledged to maintain record-low borrowing costs so as long as the unemployment rate remains above 6.5 percent and the outlook for inflation doesn’t exceed 2.5 percent.

Unemployment, Income

While unemployment has declined to 7.5 percent in April from 7.8 percent in September, growth will probably remain below average amid stagnant wages. Personal income as a percentage of output at 43.8 percent is the smallest since at least 1947, according to data from the Federal Reserve Bank of St. Louis.

As Obama and House Republicans disagree about taxes and spending, the Congressional Budget Office said May 14 the deficit will shrink this fiscal year to $642 billion, or 4 percent of gross domestic product, the smallest since 2008. The CBO sees it at $342 billion, or 2 percent of GDP, by 2015.

Forecasts of inflation have declined since mid-March. Break-even inflation rates as measured by TIPS, which represent investors’ predictions for average consumer price increases over the next 10 years, have fallen below the target 2.5 percent from 2.59 percent on March 14. The rise in the consumer price index slowed to 1.1 percent in April from 2 percent in September.

‘Soft’ Inflation

“As inflation expectations and even actual inflation continues to be very soft, that’s not an indication you need to be very fast in reducing accommodation,” Ira Jersey, an interest-rate strategist in New York at primary dealer Credit Suisse Group AG, said in a May 17 telephone interview.

Plosser of the Philadelphia Fed called this month for shrinking purchases at the Fed’s next meeting in June. San Francisco’s John Williams said the central bank “could reduce somewhat” the pace of purchases “if all goes as hoped.” New York Fed’s Dudley said May 21 he couldn’t “be sure which way -- up or down -- the next change will be.”

Bernanke said in response to questions following his Congressional testimony on May 22 that debt purchases might be adjusted in either direction as conditions warrant. We are “trying to make an assessment to see if we’ve seen real and sustainable progress in the labor market outlook,” he said.

Policy makers “seem to be doing everything now to reduce the significance of tapering as they really want to make sure the market is not going to run away from them in terms of pricing the next policy steps,” Francis Yared, the head of European rates strategy at primary dealer Deutsche Bank AG in London, said in a telephone interview May 20. The firm forecasts the 10-year yield will end 2013 at 2.25 percent.

“The tapering simply is the Fed doing less easing,” Yared said. “The Fed should be able to do that without causing major disruptions in the Treasury market.”

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