Bear Market Tightens Grip on Treasuries as Jobs Trump Housing
By Deborah Finestone
July 9 (Bloomberg) -- The bear market in U.S. Treasuries is just getting started as investors turn their attention to the strengthening labor market and faster inflation instead of the decline in home prices.
That's the conclusion of economists at Lehman Brothers Holdings Inc., Morgan Stanley and RBS Greenwich Capital. They estimate 10-year government notes will return 1.28 percent this year, not even enough to cover inflation. The performance would be the worst since 1999, when they lost 8.25 percent, Merrill Lynch & Co. index data show.
The combination of a U.S. jobless rate near a six-year low and inflation at the upper end of the Federal Reserve's comfort zone will keep the central bank from cutting interest rates to halt the decline in home prices, economists at the banks said. Federal fund futures show a 9 percent probability the Fed will cut its key rate this year. In May, the odds were 100 percent.
``It isn't a very appetizing environment'' for bond investors, said Ethan Harris, chief U.S. economist at New York- based Lehman Brothers, who says the Fed will keep its target for overnight loans between banks at 5.25 percent this year. ``The Fed is stuck in idle.''
Harris expects two-year and 10-year government debt to yield 5.10 percent by Dec. 31. Lehman is the fourth-biggest U.S. securities firm by market value.
The yield on the benchmark 4 7/8 percent Treasury due in June 2009 rose 12 basis points to 4.98 percent last week as its price fell 7/32, or $2.19 per $1,000 face amount, to 99 25/32, according to bond broker Cantor Fitzgerald LP. The 4.5 percent note maturing in May 2017 yielded 5.18 percent, up 16 basis points. The price of the securities fell 1 7/32, or $12.19 per $1,000 face amount, to 94 24/32.
Most Accurate
Lehman, New York-based Morgan Stanley and Greenwich, Connecticut-based RBS predicted the Fed wouldn't cut interest rates and that bonds would slump in the first half. Ten-year Treasuries fell 0.43 percent, according to Merrill's indexes.
They forecast, on average, that two-year notes would yield 4.92 percent. The securities ended at 4.87 percent. They also said 10-year notes would yield 4.88 percent, compared with 5.02 percent on June 30.
Those predictions were closer than the rest of Wall Street. More than 60 economists surveyed by Bloomberg News in January expected, on average, that the central bank would cut rates once by June, pushing two-year yields down to 4.71 percent and 10-year securities to 4.68 percent.
Now, Lehman, Morgan Stanley and RBS predict, on average, that two-year notes will yield 5.02 percent at the end of the year, and 10-year yields will finish at 5.12 percent.
Bond Bears
They are more pessimistic than the rest of the securities industry. Economists say two-year notes will yield 4.88 percent by the end of the year, according to the Bloomberg time weighted average of 83 estimates. Ten-year yields will decline to 4.98 percent, the average of 67 forecasts show.
Optimists underestimate the strength of the economy outside housing, according to Richard Berner, chief U.S. economist at Morgan Stanley in New York, the world's second- largest securities firm by market value behind Goldman Sachs Group Inc.
Service industries, such as airlines and banking, which make up almost 90 percent of the economy, expanded in June at the fastest since April 2006, the Institute for Supply Management in Tempe, Arizona said July 5. That suggests the economy's 0.7 percent annual growth rate in the first quarter, the slowest in four years, will pick up speed.
The Standard & Poor's 500 Index reached a record high 1540.56 on June 1. The International Monetary Fund will raise its forecast of 4.9 percent growth in the global economy this year when it updates its projections in October, Simon Johnson, the IMF's director of research, said June 26.
Return to Growth
``This is all despite a housing downturn that has a long way to go,'' Berner said. ``We're going to see a return to 3 percent growth next year because of other factors being powerful offsets.''
Berner expects the Fed to remain on hold for the year. Two-year yields will end at 5 percent and 10-year yields at 5.25 percent, he said.
Stephen Stanley, chief economist in New York at RBS, is even more of a bear. He says the Fed may raise its target rate to 5.5 percent this year to keep inflation at bay.
The Commerce Department's core inflation measure, which excludes food and fuel costs, rose 1.9 percent in May from a year earlier, the smallest year-over-year gain since March 2004. Fed members have said they prefer core inflation within a 1 percent to 2 percent range and the central bank said in a June 28 statement that ``a sustained moderation in inflation pressures has yet to be convincingly demonstrated.''
Growth in Wages
Keeping rates unchanged is the best option for promoting faster growth and slower inflation, according to Federal Reserve Bank of San Francisco President Janet Yellen.
``The virtues of this path are that it avoids exposing the economy to unnecessary risk of a downturn while, at the same time, it is likely to produce enough slack in goods and labor markets to relieve inflationary pressures,'' Yellen said in a speech by satellite to a conference in Singapore July 6.
The unemployment rate in June remained at 4.5 percent for a third month, the Labor Department said last week. The rate reached 4.4 percent in March and October, the lowest since 2001. Workers' average hourly earnings rose 3.9 percent from June of last year.
``You get to the point where the economy is pretty tight, particularly on the labor side, and it's going to be tough restraining pricing pressures,'' Stanley said. ``We expect some modest backup in market rates from here as the market comes to see the Fed will tighten.''
Housing Slump
RBS, the securities arm of Edinburgh-based Royal Bank of Scotland Group Plc, the U.K.'s second-largest bank, expects higher interest rates to drive yields on two- and 10-year notes to 5.45 percent.
Bond bulls say Treasuries will rebound because the worst slump in U.S. real estate since the 1930s will cause the Fed to cut interest rates. The National Association of Realtors said the median U.S. home price likely will decline 1.3 percent to $219,100 this year, the first annual drop since the Chicago- based trade group began keeping records.
Government bonds have recovered some losses since June 13, when yields on 10-year notes reached a five-year high of 5.327 percent. Options on fed fund futures contracts show traders see a 15 percent chance the central bank will reduce borrowing costs at least once by the end of the year, and 21 percent odds rates will rise to 5.5 percent.
Subprime Mortgages
``The indirect effects of housing are still playing out,'' said James O'Sullivan, a senior economist at UBS Securities LLC in Stamford, Connecticut. He expects the Fed to cut rates in October and sees yields on 10-year notes dropping to 4.6 percent. The firm is a unit of Zurich-based UBS AG, Europe's largest bank by assets.
Lehman, Morgan Stanley and RBS economists say the bulls have been lulled in the past month by concerns that losses on bonds backed by subprime mortgages to people with poor or limited credit will spread to the rest of the debt market and push rates higher and damping the economy.
Merrill Lynch, the world's third-biggest securities firm by market value, was among the most optimistic on bonds at the start of the year, expecting the Fed to reduce its target to 4.75 percent, driving two-year yields to 4.20 percent and 10- year yields to 4.30 percent by mid-year.
``The biggest surprise has been that we've spent four or five quarters at below-trend growth while generating no slack in the labor market,'' said David Rosenberg, chief economist for Merrill Lynch in New York.
Rosenberg last month abandoned his forecast for rate cuts this year after the central bank reiterated it's more concerned about faster inflation than slower economic growth. He now says 10-year notes will yield 5.10 percent by year-end and two-year debt will yield 5 percent.
``We'll continue to see what we saw in the first half,'' Lehman's Harris said.
To contact the reporter on this story: Deborah Finestone in New York at dfinestone@bloomberg.net
