By Daniel Kruger and Sandra Hernandez
Nov. 26 (Bloomberg) -- The good news for Treasury investors is that the U.S. economy is slowing. The bad news is that it may avoid falling into recession.
Even bulls say that the biggest rally in government debt since 2002 has pushed yields on 10-year notes so low that they can only decline if the economy shrinks. None of the 68 economists surveyed by Bloomberg News from Nov. 1 to Nov. 8 expect the economy to contract before the end of 2008.
``The market's priced to an extreme outcome,'' said Peter Kretzmer, senior economist in New York at Bank of America Corp. ``You have this dichotomy that seems to be going on between financial market behavior and the economy.''
After falling below 4 percent last week for the first time since 2005, 10-year yields will rise to 4.325 percent by year- end, according to the median forecast of the 21 primary dealers that trade directly with the Federal Reserve. The increase would mean a capital loss of 2.21 percent, Bloomberg data show. Ten- year notes returned 12 percent since yields rose as high as 5.3 percent in June, Merrill Lynch & Co. indexes show.
The Fed said Nov. 20 that it expects the economy to expand 1.8 percent to 2.5 percent in 2008. The median estimate in the Bloomberg survey is for 2.1 percent growth this year and 2.4 percent in 2008.
What concerns bond investors is that the slowing economy may lead the central bank to lower interest rates even though the dollar's 12 percent decline on a trade-weighted basis this year and the 61 percent increase in crude oil prices are causing inflation to accelerate. The consumer price index increased 3.5 percent in October from a year earlier, the fastest pace since August 2006, the government said Nov. 15.
Stagflation Danger
The last time the economy suffered through slowing growth and rising inflation, or stagflation, was in the 1970s. The 10- year note's yield rose to 10.3 percent by 1980 from 5.89 percent at the end of 1971.
``I think we have some version'' of stagflation now, said Paul McCulley, a money manager at Newport Beach, California- based Pacific Investment Management Co., which runs the world's biggest bond fund. ``We're importing a degree of inflation with the weaker dollar and oil prices, which the Fed can't do anything about. The economy is weaker.''
The Fed probably will reduce its interest rate target for overnight loans between banks to less than 3 percent from 4.5 percent now, choking off the rally, McCulley said.
Breakeven Rate
Investors are ratcheting up expectations for inflation. The gap between yields on inflation-protected 10-year Treasuries and the benchmark 10-year note has increased to 2.4 percentage points from a low of 2.2 percentage points on Sept. 5. The difference represents the average annual rate of inflation traders expect over the life of the securities.
The ``relatively good economy'' means bonds are likely to fall, said Michael Pond, an interest-rate strategist in New York at Barclays Capital Inc., a primary dealer. ``Fundamentally rates should be much higher.''
Barclays expects 10-year yields to rise to 4.6 percent and two-year yields to increase to 4 percent, from 3.08 percent last week. The firm is one of 13 primary dealers that predict the Fed will keep its target rate at 4.5 percent next month.
Bank of America's Kretzmer forecasts 10-year yields will rise to 4.35 percent and two-year notes will reach 3.55 percent because the economy won't lapse into recession.
Ten-year notes rallied as much as $15.94 per $1,000 face amount last week on growing concern that the Fed is failing to contain the fallout from the collapse of subprime mortgages.
Beating Stocks
While the Standard & Poor's 500 Index fell 1.24 percent, yields on 10-year notes dropped 17 basis points to 4 percent as the price of the 4.25 percent note due November 2017 gained about 1 3/8, or $13.75, to 102 1/32. The two-year note yield tumbled 26 basis points, or 0.26 percentage point.
Primary dealers predicted the biggest bull market for Treasuries since 2002 at the start of this year. In a Bloomberg survey in January, the firms forecast gains of 5.4 percent in 10-year notes and 5.1 percent for two-year securities.
Treasuries are poised to post higher returns than corporate debt and the S&P 500 for the first time since 2002. Treasuries of all maturities have gained 8.6 percent this year, compared with 3.9 percent for company debt, according to Merrill Indexes. The S&P 500 paid 3.3 percent, including dividends, Bloomberg data show.
The rally has driven 10-year yields 50 basis points below the target federal funds rate. The gap was 93 basis points on Sept. 10, before the Fed lowered borrowing costs half a percentage point on Sept. 18 and by a quarter point Oct. 31.
`Financial Spasm'
The central bank cut rates each of the three times since 1989 when the 10-year yield dropped below its target. Recessions followed within a year in 1989 and 2000. The Fed kept the economy from shrinking when it reduced rates in 1998 after Russia defaulted and Greenwich, Connecticut-based Long-Term Capital Management LP collapsed, requiring a $3.5 billion bailout from the world's biggest securities firms and banks.
Merrill's David Rosenberg, the most bullish economist among the primary dealers when it comes to bonds, said the Fed will slash rates to 2 percent by June 2009 because of the worst housing market in 16 years and credit-market losses.
``You either believe this is a just a temporary financial spasm and a soft patch or you believe this is going to be something a lot deeper,'' Rosenberg said.
Any evidence of growth will be enough to end the Treasury rally, said Joseph Balestrino, a senior portfolio manager in Pittsburgh at Federated Investors Inc., which oversees about $21 billion in bonds.
The government is forecast to say this week that the economy accelerated at a 4.9 percent annual pace last quarter, faster than its initial estimate of 3.9 percent on Oct. 31, according to the median estimate of 60 analysts surveyed by Bloomberg.
``Historically speaking, most of the yield decline has already occurred,'' Balestrino said. ``It's hard to be wildly bullish at this point unless you're calling for a recession. Yields will have to back higher.''
Following are the results of Bloomberg's survey of primary dealers, conducted from Nov. 16 to Nov. 23:
Firm Fed 2s 10s
BNP Paribas 4.25 3.4 4.20
Banc of America 4.5 3.55 4.35
Barclays Capital 4.5 4 4.6
Bear Stearns 4.5 3.6 4.5
Cantor Fitzgerald 4.25 3.5 4.3
Citigroup NA NA NA
Countrywide* 4.25 4.4
Credit Suisse* 4.5 3.8 4.45
Daiwa Securities* 4.5 4 4.55
Deutsche Bank 4.5 3.6 4.5
Dresdner Kleinwort 4.25 3.55 4.15
Goldman Sachs* 4.25 3.8 4.2
Greenwich Capital 4.5 3.4 4.2
HSBC Securities 4.5 3.5 4.2
J.P. Morgan 4.25 3.25 4.1
Lehman Brothers* 4.5 3.8 4.4
Merrill Lynch* 4.25 3.6 4.2
Mizuho 4.5 3.4 4.05
Morgan Stanley* 4.5 3.75 4.4
Nomura Securities 4.5 3.4 4.35
UBS 4.25 3.3 4.2
*************************************************
Median 4.5 3.60 4.325
-- With reporting by Kathleen Hays, Deirdre Bolton, Lydia Thew, Ye Xie and Deborah Finestone in New York. Editor: Liedtka (jmp)
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