Sunday, January 6, 2008

Shortest Treasuries Hold No Allure as Cuts Evoke '89 Home Slide

By Daniel Kruger

Jan. 7 (Bloomberg) -- It was the worst housing market decline since the end of World War II. The Federal Reserve was doing everything it could do to avoid a precipitous recession and investors in the shortest-term U.S. government securities had reason to be jubilant.

While two-year Treasury notes returned 10 percent in 1989 as the target rate for overnight loans between banks fell four times, no one is saying deja vu this year. Even the bond market's best start since 2001 won't get investors more than 2 percent, according to a Bloomberg survey of 65 economists and strategists.

Anyone seeking safety from the slowing economy and securities tied to subprime mortgages helped drive yields on two-year notes 1.50 percentage points below the Fed's 4.25 percent target rate last week. FAF Advisors, Federated Investors Inc., Fifth Third Asset Management Inc., Hartford Investment Management Co. and Pacific Investment Management Co., which together oversee $1 trillion, say the gap is too wide to justify buying the securities even if the Fed lowers rates as forecast.

Investors have ``priced in a dire situation,'' said Wan- Chong Kung, who manages $36 billion at FAF Advisors in Minneapolis, a unit of U.S. Bancorp. ``We certainly have to be looking at a pretty tough economic environment with no near-term prospects for a return to economic growth.''

Kung said commercial mortgage- and other asset-backed securities with the highest credit ratings offer better value than two-year notes because they were tarred along with subprime bonds. She's also buying five-year Treasuries, which are less sensitive to changes in expectations for monetary policy.

`Anything But Treasuries'

The yield on the benchmark 3.25 percent note due in December 2009 fell 35 basis points to 2.75 percent last week, according to New York-based bond broker Cantor Fitzgerald LP. The price rose 21/32, or $6.56 per $1,000 face value, to 100 30/32. Yields on five-year notes dropped 31 basis points, or 0.31 percentage point, to 3.18 percent, while 10-year notes declined 21 basis points to 3.87 percent.

``There's not much return there,'' said Bill Gross, manager of the $112.5 billion Pimco Total Return fund, the world's largest bond fund, in an interview with Bloomberg Television on Jan. 4. Newport Beach, California-based Pimco is buying ``anything but Treasuries,'' and prefers mortgage-related securities backed by Fannie Mae and Freddie Mac, he said.

The last time Fed rates were so much higher than two-year notes was in July 1989, when the gap reached 1.66 percentage points, the data show. The spread was greater than 1 percentage point twice since then. Once was in September and October 1998 following the collapse of hedge fund Long-Term Capital Management LP. The other started in November 2000 when policy makers were on the way to cutting the target rate to 1 percent.

Diminishing Returns

Fed rates were 165 basis points above the yield on two-year notes Dec. 3, the widest since 1989, Bloomberg data show.

The median forecast of 65 economists and strategists surveyed by Bloomberg is for central bank rates to fall 3.75 percent next year. They predict two-year yields will rise to 3.63 percent.

The notes returned 7.5 percent in 2007 when yields fell as low as 2.79 percent on Dec. 4 from the year's high of 5.13 percent on June 13, according to Merrill Lynch & Co. bond index data. In the 12 months from July 1989 to July 1990, the securities gained 7 percent, as the yield rose to 8.23 percent from 8.01 percent. Returns were bolstered by coupon rates more than double the current level.

Investors buying two-year notes today would earn 0.8 percent if yields rise to 3.24 percent by June 30, as economists in the Bloomberg survey predict. Buyers would get a 2.6 percent return if yields drop to 2 percent by June. Should the economy fall into a recession, the Fed may cut rates to 2 percent, bringing two-year yields with it, said Donald Ellenberger, who oversees $6 billion for Federated in Pittsburgh.

`Eye Opener'

``We don't see a great deal of value in Treasuries at these levels,'' said Ellenberger, who is buying five-year government notes to gain from any rally in shorter-term securities without taking as much risk as in two-year debt.

Funds managed by Ellenberger and Kung returned at least 7.4 percent in 2007, ranking in the top five of 154 similar funds, according to Chicago research firm Morningstar Inc. Gross was named bond manager of the year by Morningstar last week.

Brian Brennan at T. Rowe Price Group Inc. is reluctant to abandon the securities following the Fed's latest comments on the economy.

The Fed said in the minutes of its Dec. 11 meeting released Jan. 2 that ``economic growth appeared to be slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending.''

Easing Gridlock

``The forecast of below trend growth was an eye-opener for the markets,'' said Brennan, who helps oversee $11 billion in fixed-income assets at T. Rowe in Baltimore.

Payrolls rose by 18,000 in December, capping the worst year for job creation since 2003, the Labor Department said Jan. 4. That isn't as bad as during the recession of 2001, when the economy lost an average of 47,000 jobs a month.

Central bankers are making progress in easing the gridlock in credit markets caused by the subprime mortgage collapse, which was one reason they gave for reducing the target rate three times since September from 5.25 percent.

The difference between what the U.S. government and banks pay to borrow for three months, or the TED spread, narrowed to 143 basis points last week from 221 basis points on Dec. 11, the widest since August. The spread averaged 39 basis points in the first half of last year.

Skirting Recession

The economy will skirt a recession even with the housing slowdown and the increase in oil to $100 a barrel, said John Hendricks, portfolio manager at Hartford Investment in Hartford, Connecticut, which oversees $137 billion in fixed income.

``We're not that gloomy,'' he said, calling two-year yields expensive. Hendricks expects Fed rate cuts to keep the economy from contracting.

``All the gains have been achieved already,'' said Christopher Sullivan, who oversees $1.3 billion as chief investment officer in New York at the United Nations Federal Credit Union. ``Bonds have run their course for this cycle unless we get extraordinarily weaker data,'' he said after the jobs report.

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