Bond investors who drove two-year treasuries down last Friday after US Federal Reserve chairman Ben Bernanke said the economy was "beginning to emerge" from recession may find themselves wishing they had held onto the securities.
While the comments sparked speculation that the central bank may soon raise borrowing costs as growth resumes, history shows the Fed is likely to keep its benchmark interest rate at a record low for a year or more. Policy makers did not boost rates after the 2001 recession until 12 months into the recovery, while it was 17 months following the 1991 economic contraction.
"It's going to be very difficult for the Fed to raise rates simply because there's no inflation," said Michael Cheah of SunAmerica Asset Management in New Jersey. "The two-year at a yield of 1 percent is an excellent yield," he said.
The yield on the benchmark two-year note weakened by 11 basis points from 0.99 percent to 1.1 percent on the day, according to BGCantor Market Data. That was the most since the yield rose by the same amount on June 8.
The slump came after the National Association of Realtors said sales of existing US homes rose 7.2 percent to a 5.24 million annual rate, the most since August 2007, and Bernanke said at a central bankers' symposium that a return to growth in the near term appeared likely.
Speculative stances
Trading positions show that last week's sell-off may be short-lived, even as the government prepares to sell $109 billion (R855bn) of treasury notes this week, including $42bn of two-year securities.
Speculative long positions on two-year notes, or bets that prices will rise, outnumbered short positions by 158 041 contracts on the Chicago Board of Trade last week, the most since December 2007. That was just before the bonds, more sensitive to changes in Fed policy than longer-term debt, posted their biggest quarterly gain since 2001, returning 3.26 percent, Merrill Lynch indices show.
Zurich-based Credit Suisse, whose February recommendation to buy treasuries due in two years earned about 0.85 percent versus the overall treasury market's 0.7 percent loss, predicts yields will fall to 0.7 percent by the end of the year. If accurate that scenario would produce about a $100 return on a $10 000 investment.
Strategists at New York-based JPMorgan Chase, the second-largest US bank, said in a report released last week that they "recommend maintaining longs" on shorter-maturity US debt. The firms are two of the 18 primary dealers of state securities that trade with the Fed.
"Macroeconomic fundamentals continue to point to a Fed that is likely to maintain a low-for-long stance," the JPMorgan strategists, led by Srini Ramaswamy, wrote in the report.
The inflation rate was unchanged last month after rising 0.7 percent in June, the labour department in Washington said this month. Investors are betting consumer prices will fall 0.3 percent over the next 12 months and rise 0.25 percent over the next two years, compared with an average increase of 2.7 percent the past five years, prices of inflation-protected treasuries show.
No inconsistency
Fed vice-chairman Donald Kohn said the central bank's current policy to keep rates low for a long time was aimed at promoting price stability and not at spurring inflation.
"The commitment to low rates is designed to keep inflation from falling and falling persistently below what we might want it to be for a long time," Kohn said at the weekend. "It's not designed to raise inflation expectations. There's no inconsistency there."
Kohn was responding to a presentation by Carl Walsh, a professor at the University of California at Santa Cruz, suggesting the Fed's stance was "potentially inconsistent" with its low-inflation goal and "requires careful balancing".
The Fed cut its main rate to between zero and 0.25 percent in December last year and has pledged to leave it there for an "extended period".
In December 1992, the gap between two-year yields and the Fed's target rate jumped to 183 basis points. By the following March, it had narrowed to 74 points after traders realised they'd jumped the gun in anticipating higher borrowing costs.
Policy makers did not raise rates until February 1994. In September 2003, the spread hit 103 basis points before contracting to 44 in October, nine months before the Fed moved.
Even after Friday's tumble, the odds of a Fed rate increase this year are just 9 percent, down from 25 percent a month ago, futures data on the Chicago Board of Trade show.
"The two-year yield will remain extremely low" as the Fed kept rates unchanged "deep" into next year, said Stephan Hirschbrich, the head of global bonds at Union Investment in Frankfurt.
Most forecasters are convinced two-year yields are heading up. Even Hirschbrich, who is holding off on buying treasuries until yields rise, foresees 1.25 percent within six months.
All but six of 47 economists and strategists in a Bloomberg survey see higher yields by January. The median forecast of 1.35 percent, up from April's 1.05 percent prediction, would increase the spread to the Fed target rate for overnight loans between banks to as much as 110 basis points, more than twice the average of 46 basis points over the past 20 years.
Bets for a quicker increase in yields are based on speculation that the economy's recovery will resemble a "V" - a rapid slowdown followed by a robust rebound. Economists including former Fed governor Laurence Meyer and Stephen Stanley at RBS Securities say there is a reservoir of consumer demand that will emerge and buoy the economy.
"It's amazing how many shapes have been discussed," said Christian Cooper, an interest rate strategist at primary dealer RBC Capital Markets in New York, referring to recovery scenarios. "We've heard an 'L,' a 'V,' a 'UU,' a 'W'. I heard someone talk about a square-root sign" - a quick rebound followed by a sustained plateau.
Critics of the "V" recovery include Mohamed El-Erian, the chief executive of California-based Pacific Investment Management. They say there's been so much damage done to the economy during the crisis that growth will be restrained at 2 percent or less.
Taylor Rule
Bond bulls cite the Taylor Rule, an economics equation for predicting central bank policies based on policy makers' tolerance for inflation and unemployment. Using median Bloomberg survey predictions in that calculation, the rule shows the Fed keeping its benchmark rate near zero and pumping money into the economy at least through June 2010.
"The end of the recession does not mean the end of the easing cycle," economists Christian Broda and Dean Maki at London-based Barclays Capital said last week. "With a benign inflationary scenario and high amounts of slack in the economy, we expect the Fed not to raise overnight rates during 2010."
About 68.5 percent of the economy's plants and equipment was in use last month, down from the pre-crisis capacity usage average of 79 percent for the five years to 2007.
June's 68.1 percent was the lowest since at least 1967.
Following the 2001 recession, the Fed waited until the measure rose to 77.9 percent in May 2004 before raising its benchmark rate a month later from 1 percent, where it had been since the previous June and its then record low.
Way in front
Ray Remy, the head of fixed income in New York at primary dealer Daiwa Securities America, is waiting for traders to misplay their hand again. He would buy once the yield, which touched a record 0.6 percent low on December 17, hit 1.25 percent.
"The market will be way, way in front of the Fed," Remy said. "Most pullbacks are a buying opportunity, in my opinion," he said, referring to bond prices.
The two-year yield surged to 1.43 percent on June 8 and to 1.36 percent on August 7 before falling back. Both jumps followed non-farm payrolls reports than were better than economists predicted.
The latter move came after the labour department said employers cut 247 000 jobs last month, the least since before the bankruptcy of Lehman Brothers last September pushed markets into the worst crisis since the Great Depression.
"The Fed is going nowhere fast," said Cooper at RBC.
"Two-year rates are going to come lower, and we have considerable problems globally that are not going to be resolved quickly." - Bloomberg