Treasuries Slump After Bernanke Fans Speculation Rates to Rise

By Wes Goodman


June 10 (Bloomberg) -- Treasuries slumped, driving two-year yields up half a percentage point in two days, after Federal Reserve Chairman Ben S. Bernanke pledged to ``strongly resist'' any waning of public confidence in stable prices.

Two-year note yields approached the highest this year after Bernanke said the risk of a ``substantial downturn'' in U.S. economic growth has diminished, prompting traders to increase bets that policy makers will raise interest rates. The trading room at ICAP Australia Ltd. in Sydney erupted in noise after the comments, said Matthew Johnson, the firm's senior economist. The yield hasn't risen so much in two days since 1985.

``Treasuries have been decimated,'' said Kenny Borowicz, bond-futures broker at MF Global Singapore Ltd., part of the world's largest broker of exchange-traded futures and options contracts. ``All was quiet for the first two hours of trade until Bernanke's comments hit the wires. Australian and Japanese debt is also getting crushed.''

The U.S. two-year note yield rose 23 basis points to 2.94 percent as of 6:35 a.m. in London, according to bond broker BGCantor Market Data. The price of the 2.625 percent security due in May 2010 fell 13/32, or $4.06 per $1,000 face amount, to 99 13/32. A basis point is 0.01 percentage point.

Two-year rates, among the most sensitive to changes in Fed borrowing costs, may advance to 3 percent this week, ICAP's Johnson said. The high so far this year was 3.10 percent on Jan. 2. Ten-year rates climbed 4 basis points to 4.06 percent.

``The Fed is going to keep reminding us that they are worried about inflation,'' Johnson said. ``Bids disappeared for a while. Treasuries are still a sell.''

Rate Bets

Asian stocks and bonds slumped on concern the Fed will raise rates. The MSCI Asia-Pacific Index of regional stocks fell 2.2 percent. Japan's five-year bond yield rose 12 basis points to 1.41 percent. Five-year Australian bond yields rose 17 basis points to 6.84 percent. The dollar rallied to a three-month high of 106.70 against the yen.

Futures on the Chicago Board of Trade show an 88 percent chance the Fed will raise its 2 percent target for overnight lending between banks at least a quarter point by December, rising from 62 percent the previous day. A month ago, most of the bets were for no change in rates this year.

``The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so,'' Bernanke said yesterday in a speech to a Boston Fed conference. ``The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations.''

Stronger Language

Bernanke used ``somewhat stronger language than usual,'' Goldman Sachs Group Inc., the biggest securities company in the U.S., said in a report to clients. Fed officials have cut their benchmark lending rate from 5.25 percent in September to keep a U.S. housing recession and losses from the credit markets from throwing the economy into a recession.

The extra yield that two-year notes offer over the Fed's target interest rate widened to 94 basis points, the most since April 2005.

The slump in Treasuries surprised economists, who predicted two-year yields would end this month at 2.35 percent, according to the median of 48 estimates in a Bloomberg News survey. The most recent predictions are given the heaviest weightings.

``Treasuries have entered `buy' territory,'' said Adam Donaldson, head of debt research at Commonwealth Bank of Australia in Sydney, the nation's second-largest lender. ``Pressure from inflation and the economic growth slowdown will bear down on equity markets and investors will still shift asset classes to safety.''

`Complicated Balance'

The Fed faces a ``complicated balance'' of lowering interest rates to spur growth ``without taking too much risk that underlying inflation is going to accelerate,'' New York Fed Bank President Timothy Geithner said yesterday after a speech in New York.

The difference between yields on 10-year Treasury Inflation Protected Securities, or TIPS, and conventional notes widened to 2.58 percentage points from 2.45 percentage points a week ago. The figure reflects the inflation rate that traders expect for the next decade.

U.S. consumer prices rose 3.9 percent in May from a year earlier, the same as in April, according to a Bloomberg News survey of economists before the Labor Department reports the figure on June 13. That means that 10-year notes yield just 16 basis points after inflation, and shorter maturities don't yield enough to keep up with quickening prices for goods and services.

Yields on two-year notes climbed to within 1.12 percentage points of 10-year rates as traders gave up forecasts for Fed rate cuts. The difference was as wide as 2.08 percentage points in March.

``Treasuries will keep falling,'' said Mitsuo Masuda, a manager in Tokyo at the foreign bond section of Sumitomo Life, who helps oversee the equivalent of $28.1 billion in non-yen debt. ``The Fed will raise rates once or twice this year.''

Sumitomo plans to shift some Treasury holdings to euro- denominated bonds later in 2008, he said.