Treasury bonds enter bear market, impact muted

Treasury Rout Is Muffled by Reserves, Tame Inflation (Update1)
By Deborah Finestone

June 18 (Bloomberg) -- The steepest decline in Treasuries since 2004 is convincing even the most bullish investors that U.S. government bonds are now in a bear market.

Bill Gross, the manager of the world's biggest bond fund at Pacific Investment Management Co., and Dan Fuss, whose Loomis Sayles Bond Fund has been the best performer among its peers the last decade, are preparing for higher market rates after yields on 10-year Treasuries, the benchmark for home mortgages and corporate borrowing, rose to a five-year high last week.

While the rout wiped out more than $550 billion from the value of government bonds during the past month, investors don't anticipate the losses of the last two bear markets, in 1994 and 1999. The combination of demand from overseas investors, who have $5.4 trillion in currency reserves, a four-fold increase in derivatives that spread risks among a wider group of investors and the slowest inflation rate since March 2006 increase the chances that this decline will be muted, they said.

``This correction is comparatively modest,'' Jack Malvey, chief global fixed-income strategist at Lehman Brothers Holdings Inc., said in an interview in New York. ``In historical terms, it's like a rainy afternoon, not a category 5 hurricane.''

Treasuries have lost 1.53 percent this quarter, according to indexes compiled by Merrill Lynch & Co. The decline is the biggest since the 3.08 percent drop in same period of 2004 and doesn't even rank among the 10 worst quarters since New York- based Merrill created its U.S. Treasury Master index in 1978.

`Bear Market Manager'
U.S. debt returned 0.13 percent so far in 2007, compared with a loss of 1.24 percent this time last year. Treasuries dropped 3.35 percent 1994 and 2.38 percent in 1999, including reinvested interest, Merrill's index shows.

Government reports on U.S. growth and labor costs helped undermine Treasuries by convincing investors that the Federal Reserve won't reduce its 5.25 percent target interest rate for overnight loans between banks.

The odds that the central bank will cut rates fell to 20 percent last week from 56.4 percent a month ago, while the chances of a rate increase rose to 20 percent from 0.2 percent, based on options on federal funds futures

``After 25 years of being a bull market manager to all of a sudden become a bear market manager, although mildly so in terms of higher interest rates over the next three to five years, is sort of a major shift,'' Gross said on Pimco's Web site June 7. The Newport Beach, California-based company is a unit of Allianz SE in Munich.

Wider Range
Gross, who is raising his holdings of cash and cash equivalent securities while awaiting the Fed's next move, widened his forecast range for 10-year yields on concern inflation may accelerate in countries with weakening currencies such as the U.S. Ten-year yields will probably fluctuate between 4 percent and 6.5 percent until 2011, he said. Previously, Gross said the yield would say between 4 percent and 5.5 percent.

The yield on the benchmark 4 1/2 percent note due May 2017 rose 6 basis points, or 0.06 percentage point, last week to 5.167 percent, according to bond broker Cantor Fitzgerald LP. It reached a five-year high of 5.327 percent on June 13 after former Fed Chairman Alan Greenspan told investors to expect higher yields on Treasuries and emerging market debt. The price of the note fell about 3/8, or $3.75 per $1,000 face amount, to 94 7/8.

Two-year note yields, more closely linked to expectations for central bank policy, rose 3 basis points to end the week at 5.027 percent. The spread between 10-year and two-year yields widened to 14 basis points as investors gave up hopes for a rate cut and demanded more compensation for inflation risks of longer- term debt. At the start of the month, two-year notes yielded more than 10-year Treasuries. Yields were little changed today.

Transition Period
``We've been in, and are still in, a transition from a period of declining rates to a fairly long period of rising rates, maybe 20 years,'' said Fuss at Loomis Sayles in Boston. ``My guess is we're not climbing to where we'll be in the next cycle just yet.''

Even so, Fuss said he's buying longer-maturity Treasuries for his $12.3 billion fund ``as an insurance policy'' in case the economy and inflation slow.

International demand for Treasuries is one reason why investors see less fallout from this bear market. Foreign central banks doubled their holdings of U.S. bonds to $2.1 trillion in the past five years, according to Treasury Department data.

Overseas investors own about 80 percent of the $835.4 billion Treasuries due in three to 10 years, according to research by HSBC Securities USA Inc., the investment banking arm of HBSC Holdings Plc in London. Japan is the largest holder, followed by China and the U.K.

Dollar Gains
While 10-year Treasuries fell for six straight weeks, the dollar gained against the yen, a sign that Japanese investors aren't selling U.S. assets. The yen is down 3.7 percent against the U.S. currency this year.

Yields on 10-year Treasuries are 325 basis points, or 3.25 percentage points, higher than Japanese government bonds with the same maturity, the widest spread in almost four years.

``In the last four or five years, capital markets have become much more fluid than they used to be,'' J. Alfred Broaddus Jr., president of the Federal Reserve Bank of Richmond from 1993 to 2004, said in an interview from Richmond on June 15. ``An excess in savings in other parts of the world has found its way to the U.S. I don't see the forces at work that would turn this to a real bear market in bonds.''
Smaller Gyrations

Even after the 10-year Treasury note fell the most in two years on June 7, swings in yields remained near all-time lows. Merrill Lynch's MOVE Index, a measure of expectations for Treasury volatility, was 78.3 on June 14, compared with an average of 99.6 since its inception in 1988.

The gyrations are smaller, in part, because traders are using more derivatives to reduce their risks.

Financial instruments whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates, have almost quadrupled in the past eight years. They now cover $285.7 trillion in securities, compared with $58.3 trillion, according to the International Swaps and Derivatives Association in New York.

``An extreme selloff seems to be less likely in the current market compared to previous years,'' said Michael Chang, an interest-rate strategist at Credit Suisse Group in New York, one of the 21 primary dealers of U.S. government securities that trade with the Fed. ``Everything seems to be more muted. Even in a bearish market we see more days of rallies.''

Plains Exploration
The drop hasn't shut off credit to companies. Plains Exploration & Production Co. cut the size of its planned $600 million bond sale to $400 million on June 12 as Treasury yields surged. As yields fell the next day, Houston-based Plains boosted the sale back to $600 million. The notes due in 2015 were priced to yield 7.75 percent, up from the planned 7.625 percent.

Some analysts say the bull market for bonds that began Oct. 1, 1981, after Fed Chairman Paul Volcker boosted the central bank's target rate to 20 percent to stem inflation, ended on June 20, 2003. That was when the 10-year yield bottomed at 3.07 percent. Annual returns averaged 2.9 percent from 2003 through 2006, compared with 7.9 percent in the previous five years, Merrill data show.

``We've been range-bound and likely will stay that way,'' Lehman's Malvey said. A rise in 10-year yields to 5.5 percent ``cannot be ruled out,'' though an increase to 5.75 percent ``would very much surprise,'' he said in a report last week.

No Return
Investors say it's difficult to see how yields could return to the 2003 lows as the U.S. sells more debt to finance a budget deficit that will widen to $304 billion in fiscal 2009, according to Congressional Budget Office estimates.

Seventy-four percent of central banks surveyed by Zurich- based UBS AG this month said they increased their holdings of asset-backed securities, emerging market debt and other higher- risk securities this year. In the next year, 68 percent plan to add more, according to the survey, which covers banks that oversee 91 percent of the world's foreign-currency reserves.

In Europe, yields are increasing and creating more competition for Treasuries as economies in the 13-nation euro region expand and the European Central Bank signals it will continue to raise interest rates from the current 4 percent. The yield on 10-year German bunds rose to 4.657 percent last week, from 4.422 percent at the start of June.

``Interest rates are going to go higher as people allocate out of Treasuries for better opportunities,'' said E. Craig Coats, co-head of fixed income in New York at Keefe, Bruyette & Woods Inc. Coats held the same position at Salomon Brothers in the 1980s, when it was the world's biggest bond trader.

Market Rebound
Treasuries climbed at the end of last week after the Labor Department said consumer prices excluding food and energy rose 0.1 percent in May, following a 0.2 percent increase a month earlier. So-called core prices rose 2.2 percent from a year earlier, the smallest year-on-year increase since March 2006.

The real yield, or the difference between market rates on the 10-year note and core consumer prices, was 2.96 percent last week, compared with an average of 2.2 percent over the last year.

Inflation-protected Treasuries maturing in 10 years, which pay interest at lower rates than regular notes on a principal amount linked to the consumer price index, yielded 2.44 percentage points below regular notes. The difference represents the average inflation rate investors anticipate over the life of the security.

`Soon be History'
The U.S. inflation rate is above the Fed's 1 percent to 2 percent comfort zone, and some investors said it will get worse as demand for commodities from emerging markets forces prices higher. China's economy grew at an 11.1 percent annualized rate in the first quarter and crude oil rose to $68 a barrel on June 15, the highest close since September.

``We have been bond bulls for 26 years,'' said Donald G. M. Coxe, a global portfolio strategist at Bank of Montreal in Chicago, who's been in the business since 1972. ``We now believe that inflation is returning, and the great bond bull will soon be history.''

Yields on 10-year notes are close to a ``sell'' signal, according to Louise Yamada, the former chief technical analyst at Citigroup Inc. who now runs Louise Yamada Technical Research Advisors LLC in New York.

``It looks to us as if we are moving into another structural bear market for bonds,'' said Yamada, who relies on historical price patterns to forecast yields. She said the bull market lasted 23 years.

200 Years
The shift from declining rates to rising ones has happened three times in the more than 200-year history of U.S. yields, according to Yamada's research.

Each shift has lasted two to 14 years, she said, based on trends using a mix of interest-rates on foreign loans to the U.S. in the late 1700s, yields on New England municipal bonds in the 19th century, and high-quality corporate and Treasury yields in the past 100 years.
Yields may still fall to 4.75 percent to 5 percent before rising again, she said. ``Since it's the beginning of a long-term trend, the move up should be anticipated to be a gradual one.''