Bloomberg News

Treasury Welcomes Bund Losses With U.S. Seeking $1 Trillion

December 13, 2011

(Adds S&P warning on downgrades in the third paragraph.)

Dec. 5 (Bloomberg) -- Funding next year’s $1.3 trillion U.S. budget deficit may get a boost from Germany as bunds underperform Treasuries for the first time since the European debt crisis began in 2009.

While the U.S. needs to double bond sales to investors after the Federal Reserve reduced purchases, Treasuries due in 10 years or more are 2011’s best-performing sovereign securities, returning 26 percent as of Nov. 30, according to Bloomberg/EFFAS indexes. German 30-year bunds yielded more than their U.S. peers last month for the first time since May 2009 as the government was only able to find buyers for 65 percent of a 6 billion euro ($8.1 billion) offering on Nov. 23, its worst auction in 16 years.

Germany may be stripped of its AAA credit ratings as 15 euro-zone nations face downgrades by Standard & Poor’s as the region’s debt crisis deepens, underscoring the relative safety of and growing demand for Treasuries even as fixed-income measures show U.S. debt is about the most expensive on record. Bunds, Europe’s fixed-income benchmark, yielded a record high relative to Swedish bonds on Nov. 25, as the euro-region’s debt crisis begins to infect even the most stable economies.

“Supply won’t be an issue certainly for next year,” Mark MacQueen, a partner at Austin, Texas-based Sage Advisory Services Ltd., which oversees $9.5 billion, said in a telephone interview on Nov. 28. “Germany and the whole European picture is worrisome. The huge safe-haven play is ongoing demand for U.S. Treasuries and I don’t see that waning anytime soon.”

Good Timing

U.S. bond returns are poised to reach a nine-year high, even as government debt exceeds $15 trillion for the first time. While the S&P GSCI Total Return Index of commodities has risen 1 percent in 2011 and the MSCI All Country World Index of stocks has handed investors a 6.7 percent loss including dividends as of Nov. 30, Treasuries, corporate bonds, mortgage securities and other fixed-income assets are set to gain 7.3 percent this year on average, according to Bank of America Merrill Lynch index data. That would be the most since 10.3 percent in 2002.

The rally couldn’t come at a better time for the U.S. Treasury. The administration of President Barack Obama will more than double sales to investors to about $1 trillion from $454 billion in 2011 because the Fed’s stimulus programs have diminished, JPMorgan Chase & Co. said in a Nov. 25 report.

When the Treasury auctioned $35 billion of two-year notes on Nov. 21, it received $4.07 of bids for each dollar on offer, the highest ratio ever for a fixed-coupon note or bond. In a $35 billion five-year debt sale the following day, yields were set at a record low for the maturity of 0.937 percent.

Crisis Spreads

The yield on the benchmark 10-year note rose seven basis points, or 0.07 percentage point, last week to 2.04 percent, according to Bloomberg Bond Trader prices. The 2 percent note due November 2021 dropped 20/32, or $6.25 per $1,000 face amount, to 99 22/32.

The yield reached 2.16 percent on Dec. 2, the highest since Oct. 31. It climbed 1 basis point to 2.04 percent at 5:10 p.m. in New York.

The status of bunds is being threatened by Europe’s debt turmoil. Germany, France, Netherlands, Austria, Finland and Luxembourg, the euro area’s six AAA rated countries, are among the nations being placed on “CreditWatch negative,” by S&P pending the result of a summit of European Union leaders on Dec. 9, S&P said.

European Yields

The crisis that started more than two years ago in Greece sent Spanish 10-year yields to 6.78 percent on Nov. 17, the highest since the euro was created in 1999. Italian 10-year yields rose to a euro era record of 7.48 percent on Nov. 9. Italy, which has the second-largest public debt burden in the region after Greece, had to pay almost 8 percent to sell three- year debt on Nov. 29, the most since 1996.

Last month’s bund auction left the most unsold securities since 1995. The sale of debt due in January 2022 received 3.889 billion euros of bids for maximum of 6 billion euros, according to Bundesbank data.

Six central banks led by the Fed on Nov. 30 lowered the cost of dollar funding for financial companies by a half percentage point, boosting markets and lowering yields after European Union leaders said they had failed to increase the region’s bailout fund as much as planned.

“Germany was formerly considered a safe haven, but now investors looking for safety are looking elsewhere, mostly to the U.S.,” Mark Dowding, a senior fund manager at BlueBay Asset Management, which oversees $39 billion in London, said in a Nov. 29 interview.

German Bunds

Swedish 10-year yields fell to the lowest ever relative to similar-maturity bunds on Nov. 25 as the country’s borrowing costs sank 64 basis points below bunds. U.S. 10-year yields dropped to 34 basis points less than bunds on Nov. 29, after trading at 53 more in January. The spread shrank to three basis points on Dec. 2 after the move by the central banks.

Ten-year Treasury yields dropped five basis points in November, while 10-year German bunds climbed by 30 basis points, the biggest monthly increase since May 2009. The U.S. 30-year yield fell below the equivalent German rate on Nov. 29 for the first time since May 2009.

Appetite for Treasuries will persist amid a shortage of the safest fixed-income assets, Stanley Sun, a strategist at Nomura Holdings Inc. in New York, said in a Dec. 1 interview. Nomura, one of the 21 primary dealers of U.S. government securities that are obligated to bid at U.S. debt auctions, estimates net Treasury supply of about $1 trillion in 2012, the least since 2008 and less than the $1.27 trillion for 2011.

Fed Sales

Treasury needs more participation from investors as Fed Chairman Ben S. Bernanke reduces the central bank’s role in the government bond market after purchasing $2.3 trillion of Treasury and mortgage-related bonds between 2008 and June to support the economy.

Instead of continuing to buy more debt, the Fed announced on Sept. 21 it will sell $400 billion of shorter-term debt and use the proceeds to buy longer-maturity Treasuries.

While the central bank may start a new round of stimulus next quarter, it will likely buy about $545 billion in home-loan debt, according to the median estimate of 16 of 21 primary dealers surveyed by Bloomberg in the week of Nov. 21.

“While the Fed purchased 60 percent of net Treasury issuance in 2011, we expect limited net buying of Treasuries by the Fed next year,” Meera Chandan, a strategist at JPMorgan, said in an interview on Dec. 1.

Higher Yields

Foreign demand for Treasuries is strengthening, with holdings rising in September to a record $4.66 trillion, government data show. Overseas investors owned 48.4 percent of the $9.62 trillion of outstanding public Treasury debt, the most since May. China increased its stake in longer-term Treasury notes and bonds by $20.7 billion or 1.8 percent in September to $1.14 trillion, the biggest rise since March 2010. Japan, the second largest international owner, boosted its stake by 2.2 percent to $956.8 billion.

“The sovereign credit concerns in Europe will result in flight to quality bids from non-traditional Treasury buyers, but it will not persist,” Chandan said. “We expect yields to be lower in the first quarter because of the flight to quality, but as Europe stabilizes, and investor positions in Treasuries get crowded, Treasuries could decouple from Europe and yields could go higher.”

U.S. government debt is about as expensive as it’s ever been, according to the Fed’s term premium, which measures the extra yield investors demand to compensate for the risk of holding longer-term securities, based on expectations for interest rates, growth and inflation.

Yields to Rise

The gauge for the 10-year note dropped to negative 0.5 percent on Dec. 2, approaching the record negative 0.67 percent reached Sept. 22. A figure below zero suggests investors are accepting yields below fair value on the chart.

Yields on 10-year notes will rise to 2.4 percent at the end of the second quarter, according to the median estimate in a Bloomberg News survey of 66 economists. That would still be below the average of 3.96 percent over the past decade.

Though the Department of Labor said Dec. 2 the unemployment rate fell to 8.6 percent in November as employers added 120,000 jobs, government data also showed inflation remained in check as the consumer price index declined 0.1 percent in October from the prior month.

Low borrowing costs are a bonus for the government as lawmakers clash over how to reduce a budget deficit that exceeds $1 trillion. The U.S. paid $454 billion in interest expense in the fiscal year ended Sept. 30, or 3 percent of gross domestic product, less than the average 3.9 percent when the U.S. was running surpluses from 1998 through 2001, Bloomberg data show.

‘Mild Recession’

The forecast for Europe looks worse. Germany remains Europe’s largest economy and may grow by 2.7 percent this year, according to the International Monetary Fund. The Organization for Economic Cooperation and Development in Paris on Nov. 28 said the 17-member euro region is in a “mild recession,” with gross domestic product set to rise 0.2 percent in 2012.

BlueBay’s Dowding says his firm has been switching out of bunds into Treasuries as many investors “see Germany as part of the problem rather than solution.”

--With assistance from John Detrixhe and Daniel Kruger in New York. Editors: Philip Revzin, Dave Liedtka

To contact the reporters on this story: Susanne Walker in New York at swalker33@bloomberg.net; Anchalee Worrachate in London at aworrachate@bloomberg.net

To contact the editors responsible for this story: Dave Liedtka at dliedtka@bloomberg.net; Daniel Tilles at dtilles@bloomberg.net


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