March 2010

By Susanne Walker March 29 (Bloomberg) — Former Federal Reserve Chairman Alan Greenspan’s warning that rising yields on government debt will drive up American borrowing costs is resonating with the world’s biggest bond traders, who say this month’s losses in the market for U.S. Treasuries are just the beginning. Yields on 10-year notes, the benchmark for everything from mortgages to corporate bonds, climbed as high as 3.92 percent last week from a low of 3.53 percent in February. The 18 primary dealers of U.S. debt forecast the rate will reach 4.2 percent this year, the highest since October 2008, according to the median estimate in a survey by Bloomberg News. Higher yields are the “canary in the mine,” Greenspan said in a March 26 interview on Bloomberg Television’s ‘‘Political Capital With Al Hunt.” The increases reflect concern over “this huge overhang of federal debt which we have never seen before,” he said. The budget deficit , which hit $1.4 trillion in fiscal 2009, will drive Treasury sales to a record $2.43 trillion this year, a February survey of 10 dealers showed. “Bonds have seen their best days,” Bill Gross , manager of the world’s biggest bond fund at Pacific Investment Management Co., said in a March 25 interview with Tom Keene on Bloomberg radio from Pimco’s headquarters in Newport Beach, California. While Treasuries returned 0.9 percent this year, they fell after each of the government’s three note auctions last week, which drew less demand than traders estimated. Economists and strategists also predict rising yields in Germany, the U.K., Canada, Japan and the rest of world’s major economies, Bloomberg surveys show. Snowstorms, Greece “The rally in Treasuries is over,” said James Caron , head of U.S. interest-rate strategy at Morgan Stanley in New York. Storms in January and February, and concerns that Greece would default “slowed growth to a great degree,” he said. “Now things are normalizing and other indicators are showing the economy is getting better.” Morgan Stanley says U.S. yields will rise to 5.5 percent by year-end, from a nine-month high of 3.92 percent on March 25. Caron’s estimate is the highest among the primary dealers obligated to bid at government auctions. Treasuries would lose about 8.8 percent should the estimate prove correct. The 10-year Treasury yield rose 16 basis points, or 0.16 percentage point, last week to 3.85 percent, the biggest weekly increase since December. The 3.65 percent note due February 2020 fell 1 1/4, or $12.50 per $1,000 face amount, to 98 6/32, according to BGCantor Market Data. Rally Fades Treasuries surged at the start of the year, with Bank of America Merrill Lynch’s U.S. Treasury Master index gaining 1.58 percent in January, as investors sought the safety of government debt on speculation that the global recovery would falter. Those doubts diminished in February as returns slowed to 0.4 percent and disappeared this month as bonds lost 1.07 percent. Primary dealers say the losses will worsen as the U.S. economy rebounds from the worst financial turmoil since the Great Depression. Ten of the 18 dealers say the Fed will raise its target rate for overnight loans between banks before 2011. “We are no longer in the height of the financial crisis,” said Michael Pond , an interest-rate strategist in New York at Barclays Plc. “Many investors wouldn’t buy into the sustainability of the recovery until it came along with job creation. We’ll see that with this month’s employment report and those positive prints will continue.” The Labor Department may say April 2 that the U.S. added 190,000 jobs this month, after losing 36,000 in February, according to the median estimate of 62 economists surveyed by Bloomberg. Auction Demand The global economy will expand 3.6 percent in 2010, the median of 51 estimates in a separate Bloomberg survey shows, more than the 3 percent forecast they made six months ago. JPMorgan Chase & Co. expects global growth to reach “an above- trend 3.4 percent pace” as confidence improves and labor markets recover, according to a March 18 report. Bonds fell on March 23 after the Treasury’s $44 billion sale of two-year notes drew the weakest demand since December. The next day, five-year notes tumbled the most in seven months as the U.S. sold $42 billion at a higher yield than dealers forecast. Treasuries declined again on March 25 when the $32 billion auction of seven-year notes attracted the lowest ratio of bids received compared with those accepted in 10 months. Gross, who runs the $214 billion Total Return Fund , said investors should avoid the debt of the U.K. and invest in shorter-maturity U.S. and Brazilian securities and longer-term German and “core” Europe bonds. Goldman Bullish Goldman Sachs Group Inc., the world’s most profitable securities firm, is bullish on bonds. It expects inflation will remain in check as the economy expands slower than investors anticipate. Consumer prices excluding food and energy will rise at a 1 percent annual rate over the next few months, from 1.3 percent in February, the firm predicts. “Short-term U.S. interest rates will remain at rock-bottom levels for much longer than markets currently expect,” Jan Hatzius , Goldman’s chief U.S. economist, wrote in a report to clients on March 24. Goldman predicts 10-year yields will drop to 3.25 percent by year-end, the lowest of any of the primary dealers. The firm forecast at the start of 2009 the yield would end that year at 3.2 percent. It finished at 3.84 percent. While consumer prices are barely rising now, Gross said inflation will accelerate as countries sell record amounts of debt to finance deficits. Pimco announced in December that it would offer stock funds for the first time. Bunds, JGBs, Gilts The yield on the 10-year German bund will climb to 3.7 percent from 3.15 percent by the end of 2010, according to the median forecast of 17 firms in a Bloomberg News survey. Yields on Japanese government bonds of similar maturity will increase to 1.47 percent from 1.38 percent, and those in the U.K. will jump to 4.51 percent from 4.03 percent, separate surveys show. “There will be a steady march higher in sovereign debt costs,” said William O’Donnell , U.S. government bond strategist at primary dealer Royal Bank of Scotland Group Plc, in Stamford, Connecticut. “Debt service as a percentage of government expenditures will rise. There will be pressure on disposable income because household debt costs should rise.” America will use about 7 percent of tax revenue for debt payment in 2010 and almost 11 percent in 2013, while the U.K. is likely to spend 9 percent in 2013, rising to almost 12 percent under what Moody’s Investors Service describes as “adverse” scenarios. Greenspan’s Buffer Historically, there has been “a large buffer between the level of our federal debt and our capacity to borrow,” Greenspan said. “That’s narrowing. And I’m finding it very difficult to look into the future and not worry about that.” Rates for 30-year fixed U.S. mortgages rose to 4.99 percent for the week ended March 25, the highest since the period ended Feb. 25, McLean, Virginia-based Freddie Mac said in a statement. The extra yield investors demand to own corporate bonds rather than government debt shrank to the narrowest since November 2007 as faster economic growth has more than compensated for rising Treasury yields. Spreads have tightened to 151 basis points as of March 26, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. The Fed cited evidence the recovery will be slow on March 16, when it reiterated rates will stay low for an “extended” period. The central bank has kept its target rate for overnight loans between banks in a range of zero to 0.25 percent since December 2008. “Economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period,” the Federal Open Market Committee said in its statement. Too Cautious Fed Primary dealers say policy makers led by Chairman Ben S. Bernanke may be too cautious. They see the Fed raising rates to 1 percent on average this year as demand increases for cash to invest in riskier securities such as stocks and corporate bonds. “Risk appetites are rising and bonds will likely suffer,” Morgan Stanley’s Caron said. The 0.89 percent gain in Treasuries this quarter compares with 4.56 percent for the Standard & Poor’s 500 Index, 4.64 percent for speculative grade bonds, and a 2.2 percent loss for the S&P/GSCI Index of Commodities. “A labor market snapback will push the Fed into play,” said Carl Riccadonna , a senior economist in New York at Deutsche Bank AG. “They are moving in a less accommodative direction, but they will still be extremely accommodative. The peak in the unemployment rate came last fall. We should see sharper improvement over the next couple of months.” Deutsche forecasts the Fed will raise rates by August and to 1.25 percent by 2011. That rate is “not even approaching restrictive,” Riccadonna said. Following are the results of Bloomberg’s survey, conducted from March 22 to March 26. All values are for year-end: To contact the reporter on this story: Susanne Walker in New York at swalker33@bloomberg.net