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US Growth Forecasts Spell Pain for Treasurys

Michael Mackenzie, Financial Times
Thursday, 9 Dec 2010 | 5:34 AM ET

The surge in 10-year Treasury yields above the psychological 3 percent level this week crowns a miserable period for bond traders and investors who bet on the Federal Reserve’s second round of quantitative easing policy, or QE2, being bullish for the market.

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

Not since June has the yield on 10-year paper traded at 3.33 percent – Wednesday’s high. This rise in yields has wiped out all the market’s gains that were fostered ahead of QE2 being officially unveiled by the central bank last month.

The rise is part of a global phenomenon of increasing yields for the biggest western governments.

Japan, Germany and the UK have all seen their yields – still low by historical standards – shoot up in the past month.

To the shock of many in the bond market, bond purchases under QE2 have not lowered, let alone stabilised Treasury yields, while equities are now up more than 10 percent this year.

In the typically febrile atmosphere of year end when dealers scale down risk, the bearish mood in the market has only intensified in the wake of this week’s tentative deal over tax cuts between President Barack Obama and Republicans.

Aside from extending all the Bush-era tax cuts for two years and continuing unemployment benefits for 13 weeks, there is further additional stimulus in the form of a temporary 2 percent payroll tax cut – which funds social security and medicare – and business investment tax breaks.

Economists have duly revised up their growth forecasts for 2011 towards 3.5 percent.

Against the backdrop of stronger consumer and business spending, bond yields are too low, particularly when compared with equities trading at about 15 times earnings, say analysts.

“There is a lot of pain in the market,” says Dominic Konstam, interest rate strategist at Deutsche Bank.

“People are starting to fear that bonds are expensive [compared] to stocks and the case can be made for 10-year yields moving towards 3.50 percent.”

A challenge for the Fed is that sharply rising yields will not help an economy that still faces strong headwinds ranging from a depressed housing market and lacklustre job creation.

Should yields rise a full percentage point, say to 4 percent or higher, it could even threaten the recovery, ultimately sparking selling of equities.

To date, the bulk of the Treasury market’s losses are concentrated between five-, and 10-year notes, the sectors most favoured for purchase under QE2 and also favoured by investors looking to sell them back to the Fed.

“What we have here is a good old fashioned flushing out of a misplaced belief that the Fed would bail out all of those who bought bonds ahead of the Fed, that is, the QE2 trade,” says George Goncalves, head of interest rate strategy at Nomura Securities.

Clearly, bond investors have been caught out in recent days. After 10-year yields rose above 3 percent late last week, they had dropped to 2.94 percent on Monday.

“The way the market is trading feels like someone is in trouble,” said Tom di Galoma, head of US rates trading at Guggenheim Securities.

“The street does has not stomach for risk as year end approaches and people are trying to sell and finding there is limited appetite for buying Treasurys.”

The ensuing stampede out of Treasurys since the announcement of the tax deal and its new stimulus measures peaked with Wednesday’s $21 billion sale of 10-year notes, which attracted lacklustre demand.

After the auction, selling abated in the market with 10-year paper yielding 3.27 percent late in New York.

“It is extremely revealing of just how poor conditions are when we get one of the weakest 10-year auctions on record, even after the worst two day downdraft in 10-year yields since the turbulent, dark days of September, 2008,” said Mr Goncalves.

But, there are other troubling issues for bond investors. Beyond stronger growth prospects, long-term Treasury yields are also rising as the planned tax cuts will worsen the Federal budget deficit over the next two years.

That will exacerbate the already bleak longer-term borrowing picture for the US.

Lou Crandall, economist at Wrightson Icap, estimates that, pending actual details of the new stimulus programmes, the 2011 financial year deficit could reach $1,400 billion to $1,500 billion and surpass the record deficit of $1,413 billion in 2009.

The deficit is also likely to remain above $1,000 billion in 2012, he adds.

For Treasurys, the new tax cuts represent a twin blow against low yields as stronger growth forecasts combine with more debt issuance.

One small comfort is that higher yields provide investors with greater protection against the risk of future inflation.

“Treasurys are on the losing end of this deal, from the standpoint of the improved economic outlook, risk attitudes, and the US fiscal position,” says Tony Crescenzi, portfolio manager at Pimco.

Higher Treasury yields also loom as an unwelcome Christmas present for investors who have pumped record amounts of money into bond funds this year.

Appetite for bond funds in recent weeks has weakened with investors fleeing state and city issued municipal debt, whose yields have followed the path of Treasurys.

Outflows could intensify heading into the end of the year and spike early in January as investors focus on the rise in yields since the start of the fourth quarter in October.

“Historically, retail investors tend to follow the previous quarter’s performance,” says Michael Cloherty, head of interest rates strategy at RBC Capital Markets.

“It could get rougher for Treasurys early next year, once investors head for the door.”

Any signs of a strengthening economy next month will only accelerate the switch out of low yielding bonds into equities.

This has been a feature of trading since the Fed announced QE2 a month ago and satisfies policymakers who want to see risky assets rally.

“The drift north of 3 percent in 10-year yields represents a more fundamental shift in the calculus of the risk-reward trade-off,” says Richard Gilhooly, strategist at TD Securities.

While the “wealth effect” from higher stocks shows QE2 is working for now, rising yields are stinging the bond bulls.

And, if the latest shift out of Treasurys is sustained, a good deal more pain lies ahead in the bond markets.

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