Bond Dealers Say Worst Over as Demand Soars at Treasury Sales

By Daniel Kruger

June 29 (Bloomberg) -- Wall Street’s largest bond-trading firms say the worst may be over for investors in Treasuries after government securities posted their biggest first-half losses in at least three decades.

The 16 primary dealers, which trade directly with the Federal Reserve and are obligated to bid at Treasury auctions, forecast the benchmark 10-year note yield will finish the year little changed at 3.58 percent, after rising from 2.21 percent at the end of 2008, according to a survey by Bloomberg News.

The dealers, which include JPMorgan Chase & Co. and Goldman Sachs Group Inc., say the sell-off will slow after signs emerged this month that foreign buyers are scooping up record amounts of debt being sold by the Obama administration. Plus, yields at the highest since November are luring investors speculating that the economy’s recovery may be slow.

“We have seen an incredible amount of demand,” said Richard Tang, head of fixed-income sales at primary dealer RBS Securities Inc. in Stamford, Connecticut. “A lot of it is asset reallocation, out of risk assets and commodities. It’s been significant.”

The firms have been accurate so far this year. A survey in January showed they predicted Treasuries would fall as efforts to spur the economy gain traction and the flight to safety that drove the best returns in government debt since 1995 waned. Ten- year notes would lose 3.5 percent, based on the median forecast of yields in January.

Losing Bonds

The value of U.S. government debt has actually declined 4.41 percent since December, and is on a pace to post a loss for only the third time since Merrill Lynch & Co. started calculating returns with its U.S. Treasury Master index in 1978. The index rose 14 percent last year as the global economy lapsed into the worst recession in six decades.

If yields stayed constant for the remainder of the year, investors would still realize a loss for 2009 even after collecting interest payments.

Bonds rallied last week as indirect bidders, a class of investors that includes foreign central banks, purchased 67.2 percent of the record $27 billion in seven-year notes sold on June 25, or double the amount of bids than at the last sale in May. The ratio was also the highest since 2004 on the sale of a $37 billion in five-year notes the day before, while the $40 billion in two-year notes auctioned on June 23 attracted the most indirect bids in at least six years.

Budding Rally

Ten-year note yields dropped 24 basis points, or 0.24 percentage point, to 3.55 percent last week, and are down from the high of 4 percent on June 11, according to BGCantor Market Data. The price of the 3.125 percent security due in May 2019 rose 1 31/32, or $19.69 per $1,000 face amount, to 96 18/32.

“There was fear about central bank selling,” said Jeffry Feigenwinter, head of Treasury trading in New York at primary dealer BNP Paribas Securities. “When they showed up at these auctions, some of those fears were put to rest.”

The surge in demand can’t be ignored even with a change in a rule that went into effect this month that may have raised the levels of indirect bids by eliminating a provision allowing some customer awards to be classified as dealer bids, said William O’Donnell, head of Treasury strategy at RBS.

The Fed’s holdings of Treasuries on behalf of central banks and institutions from China to Norway rose by $257.2 billion this year, or 15 percent, according to data compiled by Bloomberg. That compares with an increase of $127.3 billion, or 10 percent, in the first half of 2008.

Financing the Deficit

The U.S. relies on foreign investors to finance the federal budget deficit. About 51 percent of the $6.45 trillion in marketable Treasuries are held outside the U.S., up from 35 percent in 2000, according to data compiled by the government.

Concern that international investors would pull back from American financial assets have grown as the U.S. Dollar Index weakened 9.4 percent since February after President Barack Obama and Fed Chairman Ben S. Bernanke committed $12.8 trillion to thaw frozen credit markets and snap the longest U.S. economic slump since the 1930s.

New York-based Goldman Sachs, another primary dealer, estimates that the U.S. may borrow a record $3.25 trillion this fiscal year ending Sept. 30, almost four times the $892 billion in 2008, to finance the budget deficit.

“The debt is expected to explode, as we all know,” said John Spinello, chief technical strategist in New York at primary dealer Jefferies Group Inc. “Will they maintain that 50 percent share? We don’t know.”

Dollar Concerns

The dollar fell against most of its major counterparts on June 26 after China repeated its call for a supranational currency “delinked” from sovereign nations. The People’s Bank of China said the International Monetary Fund should manage more of members’ foreign-exchange reserves.

“To prevent the deficiencies in the main reserve currency, there’s a need to create a new currency that’s delinked from the economies of the issuers,” the People’s Bank said in its 2008 review. China is the biggest foreign holder of Treasuries, with $763.5 billion as of April.

The dealers are more optimistic on bonds than most forecasters. Their 3.58 percent yield estimate compares with the average of 3.74 percent in a survey of 63 strategists and economists in a Bloomberg survey that give a higher weighting to the most recent projections.

“It feels like a recovery is getting closer,” said Brian Wesbury, an economist at First Trust Advisors LP in Lisle, Illinois. Wesbury’s forecast that the 10-year yield would rise to 3.60 percent at the end of June was the most accurate among 53 participants in a Bloomberg survey in January.

Stimulus Effects

Wesbury, whose forecast was higher than that of any other economist by 0.35 percentage point, said yields will rise to 4.5 percent by year-end. “It could even be higher,” he said. “The Fed is more willing to risk inflation” than to risk choking off growth and risk another period of economic contraction, he said.

Consumer spending rose in May as benefits from the Obama administration’s stimulus plan spurred a jump in American incomes. The 0.3 percent increase in purchases was the first gain in three months, the Commerce Department said June 26. Earnings climbed 1.4 percent, the most in a year, driving the savings rate to a 15-year high. Another report showed consumer sentiment rose in June to the highest level since February 2008.

Bernanke and his colleagues at the central bank are betting they’ll be able to pull back the credit support programs before overheating the economy and spurring inflation, which erodes the value of the fixed payments of bonds.

‘Subdued’ Inflation

Total assets on the central bank’s balance sheet grew $1.17 trillion over the past year to $2.07 trillion as the Fed loaned to banks, commercial paper issuers, and purchased bonds outright to support the flow of credit to consumers and businesses.

“Substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time,” the Federal Open Market Committee said in a statement after the two-day meeting in Washington where it also kept the benchmark interest rate between zero and 0.25 percent. The rate will stay at “exceptionally low levels” for an “extended period.”

The Labor Department said on June 18 that its consumer price index fell 1.3 percent in the year ended in May, the most since 1950. The difference between rates on 10-year notes and Treasury Inflation Protected Securities, which reflects the outlook among traders for consumer prices, narrowed to 1.70 percentage points last week, from the high this year of 2.08 percentage points on June 10.

Forecast Range

Yield estimates among the primary dealers range from a low of 2.75 percent at New York-based JPMorgan to as high as 4.3 percent at Jefferies. An investor that bought 10-year notes at the end of last week would have a return of 1.8 percent if the median estimate proves accurate.

Bonds may also get support from a strengthening dollar, bolstering the case for foreign investors to hold U.S. assets. Strategists who came closest to predicting the greenback’s value against the euro this year project the currency to appreciate as much as 17 percent in the second half as the U.S. recovers from the recession faster than Europe.

CIBC World Markets Plc, Deutsche Bank AG, Bank of America Corp. and Wells Fargo & Co. estimate the dollar will gain at least 3 percent by Dec. 31.

Trade-Off

While central bankers have indicated they accept rising Treasury yields as long as they reflect expectations for an economic recovery, further increases may put such an outcome in jeopardy.

Mortgage rates have risen in tandem with yields, potentially delaying a rebound in the housing market. The average 30-year mortgage rate increased to 5.59 percent earlier this month, the highest since November, before slipping to 5.42 percent in the week ended June 25, according to Freddie Mac, the McLean, Virginia-based mortgage-finance company.

David Rosenberg, the former chief North American economist at Merrill Lynch and the current chief economist at Toronto- based wealth manager Gluskin Sheff & Associates Inc., had the lowest forecast for 30-year Treasuries among primary dealers last year. He continues to predict gains for bond investors.

“The markets, rightly or wrongly, pricing out the recession as quickly as it did was a surprise to me,” Rosenberg said. “It’s one thing to price out a recession, it’s another thing to price in a vigorous recovery.”

Primary Dealer Year End Forecasts
                                        Two-year       10-year
BNP Paribas Securities Corp.            1.00           3.50
Banc of America Securities LLC          1.00           4.10
Barclays Capital Inc.                   1.20           4.20
Cantor Fitzgerald & Co.                 0.90           2.90
Citigroup Global Markets Inc.           1.25           3.30
Credit Suisse Securities (USA) LLC      1.25           3.00
Daiwa Securities America Inc.           1.60           4.10
Deutsche Bank Securities Inc.           1.25           3.50
Goldman, Sachs & Co.                    1.00           3.00
HSBC Securities (USA) Inc.              0.90           3.00
Jefferies & Company, Inc.               1.15           4.30
J.P. Morgan Securities Inc.             0.85           2.75
Mizuho Securities USA Inc.              1.00           3.50
Morgan Stanley & Co.                    1.20           4.25
RBS Securities Inc.                     1.50           4.10
UBS Securities LLC.                     1.80           3.80

Average                                 1.10           3.58
Median                                  1.00           3.50
High                                    1.80           4.30
Low                                     0.85           2.75