By Daniel Kruger
June 12 (Bloomberg) -- Treasuries fell, pushing the yield on the benchmark 10-year note to the highest level this year, after a larger-than-expected gain in retail sales bolstered the case for the Federal Reserve to boost interest rates.
The yield on the 10-year note has climbed 94 basis points since March 17, when the Fed backed JPMorgan Chase & Co.'s bailout of Bear Stearns Cos., a sign to traders that the seizure in credit markets caused by the subprime mortgage collapse was ending. Losses in Treasuries accelerated after policy makers signaled they would stop cutting interest rates and Fed Chairman Ben S. Bernanke said June 3 that ``we are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations.''
``The story right now is purely an inflation story,'' said David Glocke, who manages $75 billion of Treasuries at Vanguard Group Inc. in Valley Forge, Pennsylvania. ``The key issue is the market's response to increased focus by the Fed on the inflation picture.''
Ten-year note yields increased 14 basis points to 4.22 percent at 4:04 p.m. in New York, according to bond broker BGCantor Market Data. That's the highest since Dec. 27. The 3.875 percent security due May 2018 declined 1 6/32, or $11.88 per $1,000 face amount, to 97 7/32. A basis point is 0.01 percentage point.
Yields on 10-year notes had dropped to an almost five-year low of 3.28 percent on March 17. The increase in yields in the steepest in four years. Rates on three-month bills plunged to 0.39 percent, the lowest since the 1950s, the same day as investors sought the safety of the shortest maturity government debt.
Bond yields have climbed since, with Treasuries posting their worst two-months since 2004 in April and May, as the dollar weakened to a record low, crude oil climbed to an all- time high and prices of other commodities such as rice and corn surged.
Federal Reserve Bank of Philadelphia President Charles Plosser told CNBC today that central bankers ``need to act preemptively'' to forestall a jump in the inflation rate anticipated by the public. Vice Chairman Donald Kohn said yesterday that the Fed needs to counter any sign the public is beginning to expect faster increases in consumer prices.
Futures on the Chicago Board of Trade show odds of 22 percent the Fed will raise the target rate for overnight lending between banks by at least a quarter-percentage point to 2.25 percent at its June 25 meeting. The probability of an increase by year-end is 99 percent. Two months ago, the odds of a quarter-percentage point cut in the target rate was 90 percent.
The central bank has cut its target rate to 2 percent from 5.25 percent since September to keep a U.S. housing recession and credit-market losses from pushing the economy into a recession.
The Fed isn't alone suggesting higher rates. European Central Bank council member Axel Weber reiterated today the bank is ready to raise interest rates to contain inflation. Last week, ECB President Jean-Claude Trichet said a July increase in the bank's benchmark rate, now twice the fed funds target, is ``possible.''
The dollar has fallen 11 percent against a basket of six major currencies in the past year; inflation is rising at a 3.9 percent rate, almost double its pace in August.
Retail sales rose twice as much as forecast in May as Americans used their tax rebates to shop, and record gasoline prices swelled service-station receipts. Purchases climbed 1 percent, the most since November, the Commerce Department said. Purchases excluding gasoline increased 0.8 percent last month.
Inflation expectations among traders have risen this year to the highest level since August 2006. The difference between yields on 10-year Treasury Inflation Protected Securities, or TIPS, and conventional notes has widened to 2.51 percentage points, from 2.28 percentage points at the end of April. The figure reflects the inflation rate that traders expect for the next decade.
Yields on two-year notes have more than doubled to 3.05 percent since reaching 1.24 percent on March 17, the lowest since July 2003. They've risen 68 basis points since June 6, the biggest weekly increase since August 1982. Ten-year note yields have increased 31 basis points this week, the most since 2004.
Short-term Treasuries have fallen more as traders unwind bets that the yield gap between two- and 10-year notes would widen. The difference has narrowed to 118 basis points from 208 basis points on March 6. The difference, known as the yield curve, was 97 basis points at the start of 2008.
The Treasury Department sold $11 billion of 10-year notes today at a yield of 4.225 percent, the highest level on the monthly sales since November. Investors bid for 2.33 times the amount of debt on offer, compared with 2.21 in May.
In a sign that the exodus to government bonds as a haven has diminished, yields remained higher today even after Lehman Brothers Holdings Inc. replaced Chief Financial Officer Erin Callan and President Joseph Gregory. The changes come three days after the firm raised $6 billion to help survive the collapse of the mortgage market and reported the first quarterly loss since the company went public in 1994.
``We're stuck between a very hawkish Fed and stronger data, and weak financials with bank stocks making new lows,'' said Carl Lantz, an interest-rate strategist in New York at Credit Suisse Securities USA LLC, one of the 20 primary dealers that trade with the central bank. ``The constant jawboning by the Fed is outweighing any of these financial concerns.''
Banks and securities firms have posted $391 billion in writedowns and credit-market losses since the start of last year, according to data compiled by Bloomberg. The Fed has pumped $1.69 trillion through the financial system through lending programs and debt sales, along with giving Wall Street firms direct access to loans for the first time.
``The liquidity facilities are the better way to deal with the credit crisis and fed funds is somewhat decoupled from it,'' said Jamie Jackson, who oversees government debt trading at RiverSource Investments in Minneapolis, which manages $100 billion of bonds.
Banks are less reluctant to lend to each other, as seen in the gap between three-month Treasury bill yields and the three- month London interbank offered rate. The so-called TED spread is 79 basis points, down from a high of 240 basis points Aug. 20.