Treasury yield curve seen turning positive

Treasury yield curve seen turning positive
Bulls are betting that the Fed will cut borrowing costs as the economy slows while bears expect yields to rise because inflation is above Fed chief's comfort range


BOND investors are starting to bet that the Treasury market is returning to normal. Yields on two-year notes will fall below 10-year Treasuries and stay there for the first time since August, say investors ranging from Pacific Investment Management Co's Bill Gross to Colin Lundgren at RiverSource Institutional Advisors.



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Over the past decade, the so-called yield curve has been inverted only 20 per cent of the time, according to data compiled by Bloomberg. Bulls favouring shorter-term debt are betting that the Federal Reserve, which revived concerns about higher interest rates last week, will reverse course and cut borrowing costs as the economy slows. Bears selling 10-year notes expect yields to rise because inflation is above Fed chairman Ben S Bernanke's comfort zone.

Both would make the yield curve steepen, with two-year notes performing better than 10-year securities.

'Either way, a curve steepener seems the best strategy,' said Mr Gross, who manages the world's biggest bond fund for Newport Beach, California-based Pimco, which oversees US$668 billion in debt. He recommends buying short-term securities because they'll gain the most as the Fed cuts interest rates.

Investors moved more money into shorter-term securities compared with benchmark indices at the end of March than at any time in two years, according to a survey by Stone & McCarthy Research Associates in Princeton, New Jersey.

Two-year yields have exceeded those of 10-year securities since August, after the Fed raised its target rate for overnight loans between banks to 5.25 per cent. By Nov 27, short-term yields were 19 basis points, or 0.19 of a percentage point, more than 10-year notes.

Difference eliminated

That's not normal for the Treasury market, where US$4.35 trillion of securities are outstanding and investors demand higher yields for the risks of owning longer-term debt 80 per cent of the time.

Ten-year notes yielded an average of 88 basis points more than two-year notes over the past two decades, according to data compiled by Bloomberg. Two-year note yields were about 13 basis points higher than 10-year securities until the end of February when the gap narrowed as investors sought the safety of short-term debt while global equity markets slumped.

Rising concerns about inflation eliminated the difference last week. The Reuters/University of Michigan's preliminary index of sentiment for April found that consumers expect an inflation rate of 3.3 per cent in a year, compared with last month's forecast of 3 per cent.

'There are enough inflation pressures that will be nagging to the bond market,' said Mr Lundgren at RiverSource in Minneapolis, which has about US$90 billion under management. 'We see a move higher in interest rates, taking the slope a little more positive.'

Fed policy makers who met March 20-21 agreed that higher interest rates may still 'prove necessary' to control inflation, according to notes released on April 11. The minutes contained no hint of a rate cut, which some economists forecast, and suggested that officials remained confident that their prediction of an economic rebound would be borne out.

'The combination of generally weaker-than-expected economic indicators and uncomfortably high readings on inflation suggested increased downside risks to economic growth and greater uncertainty that the expected gradual decline in core inflation would materialise,' the Fed minutes said.

Yields on 4.5 per cent notes maturing in March 2009 were unchanged on Monday at about 4.77 per cent, according to bond broker Cantor Fitzgerald LP. Yields on the 4.625 per cent note due February 2017 were also unchanged at 4.77 per cent, the highest in almost two months. Two-year notes have returned 1.33 per cent so far this year, according to indices compiled by Merrill Lynch & Co. By contrast, 10-year Treasuries have returned 0.76 per cent.

'As long as there's uncertainty, interest rates will go higher farther out the curve,' said Jerry Webman, head of fixed-income in New York at OppenheimerFunds Inc, which manages about US$220 billion. It is 'normal' to see a positively sloped yield curve, he said.

Differing views

Mr Webman said that he has rarely seen such disagreement on the direction of the economy in his 35 years in the industry. Ten of the 21 so-called primary dealers that trade directly with the Fed expect the yield curve to steepen, five forecast the difference to remain little changed and five say the inverted curve will return. Citigroup Inc doesn't forecast yields for two-year notes.

UBS AG in Zurich, the world's biggest money manager, New York-based Merrill Lynch, the largest brokerage firm, and Frankfurt-based Deutsche Bank AG say that two-year note yields should fall this year because the Fed will cut interest rates to spur growth.

Pimco's View Banc of America Securities, the securities unit of the second-largest US bank, predicts that 10-year yields will rise because inflation will reach 2.6 per cent by the end of the year, up from 1.7 per cent in the second quarter. That's higher than Mr Bernanke's preferred range of between one per cent and 2 per cent and will discourage the central bank from lowering its target rate, according to the bank's analysts in New York.

Pimco's Mr Gross expects both. The Fed will cut its target rate by 'a minimum' of a half-point this year, while a weaker dollar pushes inflation higher, he said. Pimco is a unit of Munich-based Allianz SE.

The dollar touched a two-year low of US$1.3454 against the euro on April 13. A weaker dollar makes imported goods more expensive.

Ten-year notes may yield about 35 basis points more than two-year debt by year-end and more than 200 basis points within three years, said William O'Donnell, the head of US debt strategy at UBS in Stamford, Connecticut. Yields on 10-year notes haven't been two percentage points above two-year note yields since June 2004, when the Fed began raising rates.

Job growth will slow as the housing market falters, Mr O'Donnell said. The unemployment rate will rise to a two-year high of 5.1 per cent later this year, from 4.4 per cent in March, prompting the Fed to cut rates, according to UBS. Merrill Lynch economists also predict that two-year yields will decline more than 10-year notes as the Fed cuts rates to 4.25 per cent by year-end.

Morgan Stanley in New York, the second-biggest securities firm by market value, says that the gap between short and long-term yields will widen because of inflation. 'The curve should steepen no matter what,' said James Caron, the firm's head of US interest-rate strategy. 'The Fed's toleration of higher inflation has to be built into' the yield spread. Mr Caron said that 10-year notes will yield 50 basis points more than two-year debt by next year.

Stagflation, a term popular during the 1970s in the US to describe slowing growth and accelerating inflation, will also increase the slope of the yield curve, said Mr Caron. - Bloomberg