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Why Bonds May Trail Stocks Again in 2010

By Cordell Eddings

(Bloomberg) — Never have Treasuries underperformed stocks as much as in 2009, and the world's biggest bond dealers say this year may offer more of the same as the U.S. economy recovers and unemployment abates.

After soaring 14 percent in 2008 when credit markets froze, Treasuries fell 3.72 percent on average last year. Investors shunned government debt while the U.S. raised a record $2.11 trillion selling securities amid signs that the worst slump since the 1930s had ended. The losses for Treasuries contrast with the Standard & Poor's 500's 23.5 percent gain.

Wall Street's 18 primary dealers, who correctly forecast yields would rise last year as bond prices fell, see borrowing costs increasing again as the Federal Reserve withdraws some of the funding that more than doubled the central bank's balance sheet to $2.24 trillion in the last two years. Bonds will also lag behind as the Treasury keeps up the pace of record debt sales to finance an unprecedented $1.4 trillion budget deficit.

"Treasuries will have a hard time," said Michael Pond, an interest-rate strategist in New York at Barclays Plc. "There is a tremendous amount of debt for the market to buy with the economy turning around and the Fed starting to pull back."

Barclays (BCS), Goldman Sachs Group Inc. (GS), JPMorgan Chase & Co.(JPM) and the other 15 primary dealers that trade directly with the central bank forecast the benchmark 10-year U.S. note yield will rise to 4.14 percent in 2010, after surging to 3.84 percent last week from 2.21 percent at the end of 2008, according to the median estimate in a survey by Bloomberg News.

Stock Forecasts At the same time, equity strategists at JPMorgan and Goldman Sachs who predicted stocks would rebound from their steepest plunge since the Great Depression now look for the S&P 500 to rally 9.8 percent this year.

Separate surveys show that economists and strategists anticipate higher yields in Germany, the U.K. and Japan, threatening to lead the global government debt market to its first annual loss since 1999 as measured by Bank of America Merrill Lynch indexes.

The debt market increasingly expects the economy has turned the corner. U.S. gross domestic product will expand 3.5 percent in 2010, the most since 3.6 percent in 2004, as consumers boost spending and companies increase investment and hiring, said Barclays economist Dean Maki, the most-accurate forecaster of GDP in a Bloomberg News survey. Barclays sees 10-year U.S. yields rising to 4.5 percent in 2010.

$1 Trillion Flood Fed Chairman Ben S. Bernanke, who in December 2008 slashed the central bank's target rate for overnight loans between banks to virtually zero, flooded the economy with more than $1 trillion in the largest monetary expansion in U.S. history. The Fed's balance sheet expanded from $867 billion in August 2007.

Central bankers are laying the foundation for withdrawing that money before it triggers inflation. The Fed will end most emergency lending programs and debt purchases by March because of "improvements in the functioning of financial markets" and stabilizing labor markets, the Federal Open Market Committee said on Dec. 16.

The Fed proposed a program on Dec. 28 to sell term deposits to banks to absorb some of the banking system's $1 trillion in excess reserves. Central bankers are considering a proposal to schedule limited sales of bonds from its balance sheet.

Rate Outlook Policy makers will increase the benchmark rate as much as 0.75 percentage point by the end of the year from the current range of zero to 0.25 percent, according to the median of 66 forecasts compiled by Bloomberg.

"We are entering the second year of essentially zero interest rates and that's not sustainable indefinitely," said Ward McCarthy, chief financial economist at Jefferies & Co. in New York, another primary dealer.

Two-year Treasury yields, which are more sensitive to changes in monetary policy, ended last week at 1.14 percent, up from 0.77 percent a year earlier. They yielded 1.12 percent today at 7:49 a.m. in New York. The rate may rise to 1.84 percent in 2010, according to the median estimate of the dealers.

While forecasts are for higher yields, borrowing costs will likely remain below long-term averages, showing that the economy is still in jeopardy of falling back into recession with unemployment at about 10 percent. Since 1980, two-year yields have averaged 6.38 percent.

No 'Doom and Gloom' "I don't believe in the doom and gloom of Treasuries," said George Goncalves, the chief fixed-income rates strategist at primary dealer Cantor Fitzgerald LP in New York. He says 10- year notes will end next year at 3.75 percent. "If rates were to get up to anything above 4.5 percent we would see a double- dip, sending investors back to Treasuries. The economy will still not be strong enough to maintain rates that high."

While the economy expanded at a 2.2 percent pace from July through September after a yearlong contraction, the Fed said last month it sees an "extended period" of low rates. Inflation might subside while "remain reluctant to add to payrolls," policy makers said.

Unemployment will average 10.3 percent in 2010, said Edward McKelvey, a senior economist in New York at Goldman Sachs, who expects 10-year yields to drop to 3.25 percent.

High relative yields may support Treasuries by attracting international investors. Ten-year U.S. notes yield 46 basis points, or 0.46 percentage point, more than the similar-maturity German debt, up from 73 basis points less than bunds at the start of 2009.

Foreign Demand Indirect bidders, a class of investors that includes foreign central banks, purchased 45 percent of the $1.917 trillion in U.S. notes and bonds sold in 2009 through Nov. 25, up from 29 percent a year earlier, according to the Fed and data compiled by Bloomberg.

While the dealers were correct a year ago in forecasting higher yields, they underestimated the magnitude of the increase. The median estimate for 10-year yields was 3 percent.

Morgan Stanley has the highest yield outlook, with an estimate of 5.5 percent for the 10-year note. HSBC Securities has the lowest, at 3 percent.

Two-year yield forecasts range from 1 percent at Goldman Sachs and Mizuho Securities USA to 2.9 percent at RBS Greenwich Capital.

'Choppy and Uncertain' "Treasury rates will find themselves back into a range due to a still choppy and uncertain economic outlook and a hefty amount of supply that must be absorbed in due course," said Ian Lyngen, a strategist at CRT Capital Group LLC in Stamford, Connecticut, who along with David Ader were the most accurate forecasters last year when they were at RBS. "They won't back up materially beyond 4.25 percent though."

What's different in 2010 is that the Fed, the largest purchaser of U.S. government debt in 2009, won't be buying Treasuries. The central bank acquired $300 billion of the $2.11 trillion in notes, bonds and inflation-linked securities sold by the Treasury last year under a program to help cap borrowing costs that ended in October.

This year, President Barack Obama's administration will sell an estimated $2.5 trillion of notes, bonds and Treasury- Inflation Protected Securities, according to Barclays.

"With coupon issuance expected to increase and the Fed backing away as a buyer, you need to find that many more buyers," said Adam Brown, managing director and Treasury trader in New York at Barclays. "The way to find more buyers is to offer more yield."

China's Warning Yields on 10-year Treasuries rose to 2.88 percentage points more than two-year yields on Dec. 22, a record, as investors began demanding higher returns on debt sold at auction.

Peoples Bank of China Deputy Governor Zhu Min said Dec. 17 that the U.S. can't expect other nations to increase purchases of Treasuries to fund its entire fiscal shortfall. China is the largest foreign owner of Treasuries, holding $798.9 billion of the securities, according to the Treasury.

"In 2009 there was a lot of support for that supply," said Jim Caron, head of U.S. interest-rate strategy at Morgan Stanley in New York. "The question going forward is what happens when there is not?"

Pacific Investment Management Co., which runs the world's biggest bond fund, favors corporate bonds over Treasuries. Company debt returned 26 percent on average last year, including reinvested interest, according to Merrill Lynch indexes.

The supply of government debt is growing at a 30 percent pace while the corporate sector's is declining, according to a report by Mark Kiesel, global head of corporate bond portfolio management at Newport Beach, California-based Pimco. While companies sold more than $1 trillion of debt last year, an improving economy is allowing borrowers to show rising cash balances, Kiesel wrote in the report dated Dec. 28.

"As the corporate sector delevers while the federal government re-levers, bond-market technicals should increasingly turn positive for corporate bonds and negative for Treasuries," Kiesel wrote.

Following are the results of Bloomberg's survey, conducted from Dec. 19 to Dec. 31:

Firm Yld. on 2-yr. note (%) Yld. on 10-yr. note (%) BNP Paribas 1.3 3.75 Banc of America 1.5 4.25 Barclays Capital 2.3 4.5 Cantor Fitzgerald 1.75 3.75 Citigroup NA 4.45 Credit Suisse 2.25 3.75 Daiwa Securities 2.25 4.4 Deutsche Bank 2.25 4.5 Goldman Sachs 1 3.25 HSBC Securities 1.2 3 Jefferies 2.85 4.75 JPMorgan 1.75 4.5 Mizuho 1 3.9 Morgan Stanley 2.75 5.5 Nomura Securities 1.4 4.2 RBC Capital Markets 1.85 3.75 RBS Greenwich Capital 2.9 4.4 UBS 1.8 4 Median 1.84 4.14

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