Bloomberg News

Cheapest Treasuries Since 2011 Are Alluring to Gundlach

March 11, 2013

Cheapest Treasuries Since ’11 Alluring to Gundlach as PCE Falls

The Marriner S. Eccles Federal Reserve building stands in Washington, D.C. Treasuries have gotten less expensive according to the term premium, a model created by the Fed that includes expectations for interest rates, growth and inflation. Photographer: Andrew Harrer/Bloomberg

The sudden slowdown in U.S. inflation has left Treasuries at the cheapest levels in almost two years, aiding the Federal Reserve’s efforts to tamp down long-term borrowing costs while the economy improves.

Yields on 10-year notes, the benchmark measure for everything from home loans to corporate bonds, reached an 11- month high of 2.08 percent on March 8. The securities pay interest 0.88 percentage point higher than the personal consumption expenditures index deflator, the Fed’s favored inflation gauge, the widest gap since May 2011.

Growth in so-called real yields is what Fed Chairman Ben S. Bernanke needs to persuade bond investors that he has inflation under control, even after pumping more than $2.5 trillion into the economy to spur growth and bring down the jobless rate. Jeffrey Gundlach, whose $39.5 billion DoubleLine Total Return Bond Fund beat (DBLTX:US) 97 percent of its peers last year in part by avoiding U.S. government debt, said on March 5 that “relative value has swung more to the favor” of Treasuries.

“The Federal Reserve and Ben Bernanke are not concerned about inflation right now, and neither is the bond market over the short term,” Donald Ellenberger, who oversees about $10 billion as co-head of government and mortgage-backed securities at Federated Investors in Pittsburgh, said in a telephone interview March 1.

Incomes Fall

The PCE gauge, which measures household spending, rose 1.2 percent in January from a year earlier, the smallest increase since October 2009 and down from a recent high of 2.9 percent in September 2011, the Commerce Department said March 1. The central bank has said it wants to keep inflation below 2 percent.

That may be easier because payroll taxes rose in January, and $85 billion in spending cuts went into effect after Congress was unable to reach a budget agreement last month. Incomes slumped 3.6 percent, the biggest monthly drop in 20 years, the Commerce Department reported March 1.

“With all of the uncertainty over policy and the economy, and with no inflation pressures to speak of, the market has found equilibrium,” Ellenberger said.

Yields on 10-year notes rose 20 basis points, or 0.20 percentage point, to 2.04 percent last week in New York trading, the biggest increase since the five days ended March 16, 2012, according to Bloomberg Bond Trader prices. The yield touched 2.08 percent, the highest since April 5, 2012, after falling for the previous two weeks and sinking 11 basis points in February. The 10-year notes yielded 2.05 percent at 9:04 a.m. in New York.

Unemployment Rate

The unemployment rate unexpectedly declined to 7.7 percent, the lowest since December 2008, from 7.9 percent as the economy added 236,000 jobs in February, the Labor Department said March 8. It’s still above the Fed’s target of less than 6.5 percent. The median forecast of economists in a Bloomberg News survey was for an increase of 165,000. Average hourly earnings rose 0.2 percent to $23.82.

Real yields have begun to reward investors, recovering from negative levels as recently as November, even though the gap between the Fed’s inflation measure and the benchmark 10-year note is still below its 10-year average of 1.38 percent.

Another measure of the relative value of U.S bonds with maturities of more than 10 years shows them yielding 0.44 percentage point more than comparable global sovereign debt. That makes the securities the cheapest since August 2011, according to Bank of America Merrill Lynch indexes.

Term Premium

Treasuries have also gotten less expensive according to the term premium, a model created by the Fed that includes expectations for interest rates, growth and inflation. With a 30-day moving average of negative 0.65 percent, the measure shows 10-year notes are the cheapest since May, after they were the costliest ever in December.

While the U.S. is exhibiting slow growth, expected to grow at a 1.8 percent this year, other developed countries have it worse as the euro-area economy, still grappling with the effects of a debt crisis, may shrink by 0.1 percent this year, surveys of economists by Bloomberg show. The U.S. is also expected to fare better than the average of 1.15 percent growth expected in the Group of 10 developed nations.

There is “a long road ahead of these low rates,” Jay Mueller, who manages about $3 billion of bonds at Wells Fargo Capital Management in Milwaukee, said in a telephone interview March 5. “It’s easy to look at the U.S. and see all of these problems, until you look around the world and see everybody has these problems and more. As a consequence, you are seeing dollar-denominated assets do well, and that includes Treasuries.”

Fed Purchases

Consumer prices will rise 1.8 percent this year, according to a Bloomberg survey of economists. A bond market measure used by the Fed to forecast inflation for the five years starting in 2018 has fallen to 2.83 percent from a high this year of 2.89 percent on Jan. 29, and is about the average for this gauge over the past decade.

Yields are also being held down by Fed purchases of $85 billion a month in Treasuries and mortgage bonds aimed at boosting growth and demand for the safest assets amid a dwindling supply.

Investors submitted $3.05 in bids for each dollar of the $360 billion auctioned by the Treasury this year, second only to last year’s ratio of $3.15.

Global supply of the highest-quality bonds, as measured by ratings companies, is poised to fall to $6 trillion from $10 trillion before the global financial crisis, according to an International Monetary Fund report in January. Reforms such as the Dodd-Frank financial-overhaul law and global regulations set by the Bank for International Settlements in Basel, Switzerland, require institutions to hold more top-graded debt as a cushion against potential losses.

Bull Market

“The shortage of debt and the sluggish recovery and employment situation have paved the way for low yields for some time,” James Sarni, senior managing partner at Payden & Rygel in Los Angeles, which oversees $75 billion, said on March 6 in a telephone interview.

While Treasuries have lost 1.13 percent this year, the worst start since 2009, the bull market for bonds that began in 1980 has shown few signs of reversing. Since the 2008 collapse of the subprime-mortgage market triggered the worst financial crisis since the Great Depression, government debt maturing in 10 or more years has returned 48 percent, compared with the 28 percent gain for the Standard & Poor’s 500 stock index.

Longer term, the best may be over for bonds, according to Zach Pandl of Minneapolis-based Columbia Management Investment Advisers LLC. He says Treasuries may have zero total returns for the next two years.

Inflation ’Overshoot’

The market expects inflation to rise, according to the 10- year break-even rate, the difference in yields between government notes and Treasury Inflation Protected Securities. This measure has increased to 2.58 percentage points from a 2012 low of 2 percent in January. Yields will rise to 2.26 percent at year end, according to the median forecast of analysts in a Bloomberg survey.

“Given the improving economy and the depressed levels of rates, investors aren’t being compensated enough in Treasuries and rising rates make sense,” Pandl, senior interest-rate strategist for Columbia, which oversees $340 billion, said in a telephone interview March 6. “Everyone recognizes that the Fed is pursuing an aggressive policy that raises the probability of an overshoot of their inflation target, even as inflation is still low and employment still high.”

For now, demand is being boosted by the better returns, converting bond bears to bulls as 10-year notes gained 1.24 percent in February, reversing in part the 1.98 percent losses from January, according to Bank of America indexes.

Gundlach Buys

“Relative value has swung more to the favor of Treasuries,” Gundlach, whose Los Angeles-based DoubleLine manages about $53 billion, said in a March 5 webcast. After telling investors that Treasuries were overvalued in July, DoubleLine resumed buying government securities when yields rose, he said.

Policy makers cut their target interest rate to a range of zero to 0.25 percent in December 2008. Last year they said it will stay there while unemployment remains above 6.5 percent and inflation is no more than 2.5 percent. The Federal Open Market Committee said at its January meeting it will continue asset purchases until the labor market improves “substantially,” according to minutes released on January 30.

Beige Book

Bernanke defended the Fed’s bond purchases in testimony to Congress on Feb. 26, saying the benefits of reducing borrowing costs and fueling growth outweigh any potential harm from rising inflation as a result of the bond purchases. The Fed said price pressures were “modest” in its Beige Book business survey, released March 6, which is based on reports from its 12 regional banks.

The tax increases and budget cuts that went into effect Jan. 1 may trim as much as 0.6 percentage point off gross domestic product, Congressional Budget Office Director Douglas Elmendorf told lawmakers at a hearing on Feb. 13. GDP will expand 1.8 percent in 2013, down from 2.2 percent in 2012, according to the median estimate of 75 economists surveyed by Bloomberg.

Bernanke has faced limited inflation so far, as the PCE has averaged 2.1 percent since he took office in January 2006, according to Commerce Department data compiled by Bloomberg. That’s below the 3.8 percent average from the January 1960 start of monthly data until the beginning of his term.

“Unemployment is still high, inflation still benign, the Fed is still supporting the market and there are still problems globally, which means low yields,” Matthew Duch, a fund manager at Calvert Investments in Bethesda, Maryland, which oversees more than $12 billion in assets, said in a telephone interview March. 5. “You aren’t going to get outsized returns, but yields certainly aren’t going to spike in this new rate environment any time soon.”

To contact the reporter on this story: Cordell Eddings in New York at ceddings@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net


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