Aug. 6 (Bloomberg) -- So much for the bear market in Treasuries.
Yields on 10-year notes fell below where they started in January after climbing to a five-year high in June. Government securities are on track to return 5.3 percent this year, the best performance since gaining 12 percent in 2002, Merrill Lynch & Co. index data show.
Government debt is suddenly hot, as investors from New York to Tokyo seek safety from declining corporate and mortgage-bond prices brought on by the worst real estate recession in 16 years. At the same time, the federal budget deficit is shrinking and the economy is producing fewer jobs than analysts forecast, leading traders to step up bets that the Federal Reserve will cut interest rates this year.
``There will be a strong bond market to close the year,'' said Lacy Hunt, chief economist at Austin, Texas-based Hoisington Investment Management Co., which oversees about $5 billion and has beaten the Lehman Brothers Aggregate Bond index by 2.5 percentage points a year on average the past three years. ``By the end of the year or next year, the economy will be in a recession. That will bring on increased demand for Treasuries.''
Bear Stearns Cos. Chief Financial Officer Sam Molinaro said on a conference call Aug. 3 that the rout in credit markets is as bad as anything he has seen in his 22 years on Wall Street, rivaling the periods after the collapse of hedge fund Long Term Capital Management in 1998 and the bankruptcy of energy trader Enron Corp. in 2001.
`Flight to Quality'
The government is one of the biggest beneficiaries of lower rates. The Treasury will sell $22 billion of 10- and 30-year bonds this week.
``We're going to see a continuation of the flight to quality, which would obviously help the auction,'' said John Flahive, who manages $17 billion as director of fixed income at BNY Mellon Wealth Management in Boston.
The benchmark 4.5 percent Treasury due in May 2017 has rallied in the last four weeks, with its yield dropping half a percentage point. The yield on the benchmark 10-year note gained 1 basis point today to 4.69 percent as of 11:48 a.m. in London, according to bond broker Cantor Fitzgerald LP. The yield rose as high as 5.327 percent in June.
Treasuries returned 1.66 percent in July when including reinvested interest, the best performance since April 2005 and second among major government bonds markets after U.K. gilts, which climbed 2.66 percent, Merrill Lynch index data show.
U.S. securities had the biggest gain of last week on Aug. 3, when the Labor Department in Washington said employers added 92,000 jobs in July, down from 126,000 the prior month. The jobless rate increased to 4.6 percent from 4.5 percent. A separate report the same day from the Institute for Supply Management showed service industries, which include banks and retailers, expanded in July by less than economists forecast.
Bears Buy
That same day Barclays Capital and JPMorgan Chase & Co. abandoned predictions that the Fed would increase its 5.25 percent target rate for overnight loans between banks this year. A month ago they said the lowest jobless rate in about six years would allow the economy to weather the decline in home prices and sales.
The latest reports were enough to turn even bearish investors into buyers.
Dan Fuss of Loomis Sayles & Co. in Boston purchased Treasuries last week. As recently as June, he said the U.S. government debt market is the midst of a transition from declining to rising rates over the next two decades.
``We bought some today,'' Fuss who oversees $22 billion as vice chairman of Loomis Sayles, said Aug. 3. ``They're a good insurance policy if rates really go down. They also make a nice, liquid reserve if the credit market really cracks.''
Yield Signal
Central bank policy makers meet tomorrow. All 89 economists surveyed by Bloomberg expect them to keep their target rate unchanged. Options on federal fund futures show traders see a 56 percent chance the Fed will cut rates by year-end, up from 22 percent in mid-June.
Two-year notes suggest the Fed will soon cut borrowing costs. The benchmark 4 5/8 percent note due in July 2009 yields 4.43 percent, or 0.82 percentage point less than the Fed's key rate. The last time the gap was so wide was 2001, when the central bank reduced rates 11 times, to 1.75 percent from 6.50 percent, to try and pull the economy out of a recession.
The Treasury market has been ``pretty accurate in telling us what's going on in the real economy, and its showing we're growing a little bit below expectations,'' said James Swanson, who helps oversee $192 billion as chief investment strategist at Boston-based MFS Investment Management. The firm is ``overweight'' Treasuries, meaning it owns a greater percentage of the securities than is contained in benchmark indexes.
`Broken' Bull Market
Just two months ago, bulls were turning into bears as the combination of U.S. government reports showing rising labor costs and lower worker productivity and a surprise increase in New Zealand interest rates led investors to suspect that the global economy was starting to heat up.
In the week ended June 8, 15 of the 21 banks and securities firms that trade with the Fed changed their outlooks for lower rates or increased forecasts for bond yields. Analysts who rely on historical price patterns said as early as April that charts indicate a transition to a long-term bear market for Treasuries.
``The 25-year bull market uptrend in bonds has been broken,'' Louise Yamada, the former chief technical analyst at Citigroup Inc. who now runs Louise Yamada Technical Research Advisors LLC in New York, said last week. ``It's not a question of if, but when.''
Subprime Decline
Sentiment started to change again in July on speculation that losses at hedge funds owning subprime mortgage bonds would spread and slow the economy. Last week, the latest S&P/Case- Shiller index of home prices in 10 major cities showed a decline of 3.4 percent in May from a year earlier, the biggest drop since 1991.
Over the past two months investors became concerned about lax lending standards in the corporate bond and loan markets. Companies were forced to abandon or rework more than $45 billion of debt sales and new issues slowed to $39.5 billion in July, the lowest since April 2005, data compiled by Bloomberg show.
High-yield, high-risk, or junk, bonds fell 3.14 percent in July, the most in five years, as investors fled. Bonds rated below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's are considered junk.
The gains have made Treasuries too expensive, according to Roger Bridges, who helps manage the equivalent of $5.12 billion of debt at Tyndall Investment Management Australia Ltd. in Sydney.
``The flight to quality has sent yields down way below what we would consider to be fair value,'' Bridges said. ``For a 10- year yield at 4.70, you've got to have quite a dramatic cut in the fed funds rate to justify that type of level.''
International Surprise
Tyndall considers yields on 10-year notes above 5 percent as ``fair value,'' and may trim its holdings, according to Bridges.
International investors have been another surprise, increasing their holdings of U.S. government debt securities by $79.9 billion this year through May to $2.18 trillion, according to the Treasury Department. That is double the increase of $37.9 billion in the same period last year.
Speculation that international investors, who own more than half of all Treasuries, would slow their purchases fueled concerns about U.S. bonds. Central banks in China and Egypt have said they are diversifying reserves away from U.S. debt, seeking higher returns in other investments amid global growth.
``On the margin we're seeing diversification, but foreign investors have reasons to not pull the rug out from under U.S. Treasuries,'' said Jerry Webman, head of fixed-income in New York at OppenheimerFunds Inc., which manages about $220 billion.
Last Auction
At the last auction of 10-year Treasuries on May 8, indirect bidders, the class that includes foreign central banks, bought 44.3 percent of the debt, the most since November 2005.
The $22 billion government auction this week will be the smallest so-called quarterly refunding since 2001, as rising tax receipts allow the government to cut borrowing.
A projected 7 percent increase in tax revenue will help the U.S. budget deficit shrink by 17 percent to about $205 billion for the fiscal year ending Sept. 30, the Bush administration said last month.
``We're bullish on Treasuries,'' said Tsutomu Komiya, who helps oversee the equivalent of $26.6 billion of debt at Daiwa Asset Management Co. in Tokyo. Komiya said he will increase his holdings if the Fed suggests during its policy meeting on Aug. 7 that it is concerned housing is slowing growth.
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