Sunday, April 6, 2008

Good News for Bernanke From Bond Market Is Bad News for Rates

By Daniel Kruger and Sandra Hernandez

April 7 (Bloomberg) -- For the first time since December, the bond market is closing the credibility gap with Ben S. Bernanke and signaling its agreement with the Federal Reserve chairman that an economic collapse has been averted and that interest rates are bottoming.

Treasury yields rose 0.33 percentage point on average through April 4 from this year's low of 2.49 percent on March 17, according to Merrill Lynch & Co. indexes. The increase is the first since December, when the Fed cut its target rate for overnight loans between banks and said lower borrowing costs ``should help promote moderate growth.''

The Fed's unprecedented support for JPMorgan Chase & Co.'s takeover of New York-based Bear Stearns Cos. on March 16 is restoring confidence in Bernanke, who told Congress last week that ``monetary and fiscal policies are in train that should support a return to growth.'' Yields tumbled to the lowest levels since 2003 in the first quarter, when banks racked up $232 billion of losses and writedowns and the economy lost jobs.

``There is a sense of stability returning to the market,'' said John Hendricks, who helps oversee $137 billion at Hartford Investment Management Co. in Hartford, Connecticut. ``Bernanke's comments that there's a significant amount of monetary easing already in the system and you've got these other measures coming into play as well that should help the economy rebound in the second half.''

The turning point came when the Fed promised $30 billion to back New York-based JPMorgan's bailout of Bear Stearns, preventing the biggest collapse of an investment bank. The central bank lowered its pledge to $29 billion on March 24 after JPMorgan quadrupled the purchase price to about $2.4 billion.

Recession Risk

Treasuries, which tend to perform the best when the economy and inflation are slowing, lost 1.59 percent on average since March 17, according to Merrill's indexes. They had gained 14.5 percent since June 12 as gross domestic product growth slowed to a 0.6 percent annual rate in the fourth quarter, home prices fell 14 percent and bank losses swelled.

High-yield, high-risk corporate bonds returned 2.46 percent following the Bear Stearns rescue, after losing 4.58 percent this year through March 17, the Merrill indexes show.

While acknowledging for the first time that the economy may be in a recession, Bernanke told the Joint Economic Committee of Congress last week that the Fed's actions ``will help to promote growth over time and to mitigate the risks to economic activity.''

The bond market is looking much like it did in December, when yields rose as much as 0.27 percentage point to 3.91 percent on average. The rise followed the Fed's decision to cut its target for overnight loans between banks to 4.25 percent on Dec. 11.

Fed Remedy

Bernanke is persuading bond investors of his ability to manage the economy after the Fed reduced the target federal funds rate to 2.25 percent, pumped $628 billion through the financial system and allowed securities firms to borrow directly from the central bank for the first time since it was created in 1913.

The difference between what banks and the government pay to borrow is narrowing as confidence starts to return to capital markets frozen by the subprime collapse.

The gap between three-month Treasury bill yields and the three-month London interbank offered rate narrowed to 1.29 percentage points last week from 2.03 percentage points on March 19. The spread reached 2.20 percent on Dec. 11 as investors rushed for the security of government debt and banks limited loans to each other, driving up loan costs.

Rally Interrupted

``You started seeing some improvement,'' said Andrew Harding, who helps manage $18 billion as chief investment officer for fixed income at Allegiant Asset Management in Cleveland. ``There's been a series of positive events,'' said Harding.

Harding is buying corporate bonds, including those of financial companies, and mortgage-backed securities issued by government-chartered home finance companies Fannie Mae and Freddie Mac.

The slump in Treasuries since the bailout of Bear Stearns was interrupted on April 4 after the Labor Department said company payrolls contracted by the most in five years during March. At the same time, wages grew at the slowest pace since 2005, bolstering speculation that inflation will decline as Bernanke said it would.

``It is our expectation,'' Bernanke said in response to questions from members of the Senate Banking Committee on April 3, that ``overall inflation will tend to slow.''

Breakeven Rates

Yields on 10-year Treasury Inflation Protected Securities fell to 2.29 percentage points less than 10-year notes at the end of last week, from the high this year of 2.56 percentage points on March 7. The so-called breakeven rate reflects the annual rate of inflation that traders expect for the next decade.

The April 4 rally wasn't enough to keep Treasuries from declining last week. Two-year note yields climbed 17 basis points to 1.82 percent, and are up from 1.24 percent on March 17, the lowest since July 2003, according to bond broker Cantor Fitzgerald LP. The price of the 1.75 percent note due March 2010 declined 11/32, or $3.44 per $1,000 face amount, to 99 28/32.

Any gains in Treasuries may be limited this week because government reports are likely to show that the trade deficit for February narrowed and the budget gap shrank in March, according to the median forecast of more than 20 economists surveyed by Bloomberg News.

`Easing Mode'

``Much of the bad news has been priced in,'' said Colin Lundgren, head of institutional fixed income in Minneapolis at RiverSource Investments, which manages $100 billion of bonds. ``I'm not sure Treasuries in the next six to 12 months look that appealing, even though we're in a slowdown and the Fed is still in easing mode.''

A weekly survey by Ried, Thunberg & Co. shows that investors who oversee $1.47 trillion expect 10-year Treasury yields to rise by the end of June. The Jersey City, New Jersey- based firm's sentiment index was 48 on April 4, compared with 46 a week earlier. Readings below 50 mean investors anticipate lower prices.

It may be too early to become optimistic about the economy, according to Stuart Spodek, co-head of U.S. bonds in New York at BlackRock Inc., which manages $513 billion in debt.

``The market's perhaps responding to the end of what was perceived to be a liquidity crisis or credit crunch,'' he said. ``You can make a very strong argument based on the chairman's comments and some of the data that the fundamental picture and the real economy picture haven't improved.''

`Calmed Down'

The economy may expand 2.1 percent in the third quarter, from 0.55 percent this quarter and 0.2 percent in the first three months of the year, according to the median estimate of 85 economists surveyed by Bloomberg.

Traders see a 36 percent chance the Fed will lower rates by a half-percentage point to 1.75 percent at their next scheduled meeting on April 30, down from 48 percent on March 28, according to interest-rate futures contracts on the Chicago Board of Trade.

Treasuries even fell on April 1, when UBS AG, Switzerland's biggest bank by assets, reported $19 billion of credit costs, and Deutsche Bank AG, Germany's largest bank, said it will write down $3.9 billion of loans and asset-backed debt.

``We're losing a little of the safe-haven bid,'' said Hendricks. ``Time will tell as to whether people are jumping the gun here or whether there's going to be another leg down, but for the moment the markets have definitely calmed down.''

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