Gross, Gundlach: Contrarians expecting yields to fall

Big bond dealers see economy improving while others question recovery

Feb 18, 2014 @ 7:46 am

The world's biggest bond dealers are showing almost no confidence in the best annual start for Treasuries since 2008.

While Treasuries have climbed 1.4% this year, Goldman Sachs Group Inc., JPMorgan Chase & Co. and the other 20 primary dealers offered to sell $4.34 of the notes for every dollar the Federal Reserve purchased from the firms in its bond-buying program in the past month, the highest since 2011, data compiled by Bloomberg show. Dealers slashed inventories more than 70% from a record in October to a two-year low.

The increased selling shows that bond dealers are becoming decidedly bullish on the world's largest economy at a time when investors such as Pacific Investment Management Co. are questioning the strength of the U.S. recovery in the wake of reports on jobs growth, manufacturing and retail sales that fell short of analysts' estimates. Primary dealers surveyed by Bloomberg predict the Treasury gains will turn into losses, pushing up yields on 10-year notes to 3.49% by year-end.

“The window for bond prices to rise is limited,” said Scott Minerd, who oversees $190 billion as the global chief investment officer at Guggenheim Partners. “The market will look back at this time as a buying opportunity for risk assets.”

Treasuries started the year with the best January returns since the financial crisis, rebounding from their first annual losses since 2009. The notes tumbled in 2013 as U.S. growth accelerated in three straight quarters for the first time in a decade and the Fed moved to curtail its unprecedented stimulus.


U.S. government bonds have benefited this year as reports raised concern the economy was losing some momentum and investors sought shelter from a rout in emerging-markets assets.

As bond buyers poured into Treasuries, primary dealers, which are obligated to bid at U.S. debt auctions, moved to trim their own exposure. They offered to sell $174 billion of bonds to the Fed in the past four weeks, data compiled by Bloomberg show. The amount was more than quadruple the $41 billion the central bank purchased in the same span.

The average offer-to-cover ratio is now the highest since November 2011, data compiled by Bloomberg show. It averaged 3.2 times last year and fell to a record-low 2.54 in July, when Treasuries were in the midst of a selloff that lifted 10-year yields from 1.61% in May to 3.01% in September.

Dealer positions in Treasuries fell to $39 billion at the end of January, the lowest since December 2011. In October, they had a record $146 billion of government bonds.

“No one should be buying into these levels,” said Joseph LaVorgna, the chief U.S. economist at Deutsche Bank, one of the primary dealers that trade with the Fed. “Treasuries don't offer a good margin of safety right now.”

Mr. LaVorgna sees 10-year yields at 4% by year-end.

While the pullback intensified as Treasuries rallied, 10-year yields have now risen for two straight weeks. Yields, which touched a three-month low of 2.57% on Feb. 3, ended at 2.75% last week, Bloomberg Bond Trader data show. The price of the 2.75% security maturing in February 2024 declined 3/32, or 94 cents per $1,000 face amount, to 100 1/32 on Feb. 14.

Treasuries are bound to resume their gains as investors come to realize just how weak the expansion has become, said Robert Tipp, chief investment strategist at Prudential Financial Inc.'s fixed-income unit, which oversees $397 billion.

U.S. employers hired 113,000 workers last month after adding 75,000 in December, the slowest two-month stretch of job growth in three years, government reports showed.


Factories expanded in January at the weakest pace in eight months as colder winter weather slowed demand, according to the Institute for Supply Management. Last week, a report showed retail sales last month fell by the most since June 2012.

The Fed's preferred measure of U.S. inflation, the personal consumption expenditures deflator, has also failed to meet the Fed's 2% target for 20 straight months.

“There is real evidence that there is a deceleration,” Mr. Tipp said in a telephone interview. “Tapering is priced in at this point, while an adequate appreciation of the prospects for weaker growth and inflation are not, and that is going to mean lower yields for longer than the market is expecting.”

Two of the biggest debt investors agree. Bill Gross, Pimco's co-founder, said 10-year yields can fall further if labor growth remains subdued and low inflation persists. His $237 billion Total Return Fund increased Treasuries and government-related debt to 46% in January, the highest since at least July, from 45% in December.

Jeffrey Gundlach, who oversees $49 billion as chief executive officer of DoubleLine Capital, said last month Treasury yields will fall in 2014.

Those predictions conflict with forecasters who predict U.S. borrowing costs will keep rising. Based on the median of 73 estimates in a Feb. 13 Bloomberg survey, yields on the 10-year note will reach 3.4% by year-end. The 15 primary dealers providing projections have an average estimate of 3.49%.

“The rally in Treasuries was an overreaction,” said Priya Misra, the head of U.S. rates strategy at Bank of America Corp., a primary dealer. “We've more than priced in the economic weakness we've seen.”

That view is supported by economists, who last week boosted projections for U.S. growth even after the most recent reports on jobs and manufacturing fell short of their forecasts. They now see the economy expanding 2.9% this year, the most in a decade, data compiled by Bloomberg show.


Before the January payroll figures, which spurred gains in Treasuries when they were released on Jan. 16, economists predicted growth of 2.6%.

Fed Chairman Janet Yellen was also unswayed by the jobs report and signaled the bar is high for any change to the Fed's plan to reduce stimulus. While Ms. Yellen acknowledged the labor market recovery is “far from complete” in congressional testimony last week, she pledged to maintain her predecessor's policy in “measured steps” as the economy improves.

The Fed has trimmed its $85 billion of monthly bond buying by $10 billion in both January and February. Economists estimate that pace will continue until the central bank ends the program at the end of the year.

“It's clear that Janet Yellen, who a lot of people thought would be more dovish, is sticking to the script with regard to tapering,” said Ira Jersey, an interest-rate strategist at Credit Suisse Group. “The slowdown we are seeing this quarter will quickly dissipate and good growth will take its place.”

Credit Suisse, a primary dealer, forecasts 10-year Treasuries yielding 3.65% by year-end.

Joblessness, which peaked at 10% in October 2009, has already fallen faster than Fed officials anticipated. When they announced in December 2012 the 6.5% threshold as the basis for raising its benchmark interest rate, most predicted the unemployment rate would decrease to 6.8% to 7.3% at the end of this year. The rate dropped to 6.6% last month, the least since October 2008.

Some indicators this month reflect greater optimism in the U.S. recovery. Services, the biggest part of the economy, expanded more than forecast in January, the ISM said on Feb. 5. Consumer confidence improved for the first time in five weeks, the Bloomberg Consumer Comfort Index showed.

“I am not seeing a U.S. economy that's falling off a cliff,” said Andrew Milligan, head of global strategy at Standard Life Investments, which manages $270 billion. “I look at the U.S. 10-year and ask, 'Is it still likely that yields ultimately go higher than lower?' The answer is yes.”

Another reason that Treasuries are a sell is the potential for inflation to pick up this year, according to David Rosenberg, the chief economist at Gluskin Sheff & Associates.

The former Merrill Lynch chief economist for North America, among the earliest to warn of the housing bubble in 2005, said consumer prices will jump as “the mother of all reflationary policies” leads to higher wages and rents. Since 2008, the Fed has inundated the economy with $3 trillion.

While U.S. living costs fell to a four-year low of 1.48% last year, investors demanded a record $155 billion of Treasury inflation-protected securities. The bonds have outperformed nominal Treasuries this year, posting the biggest gains since 2008, index data compiled by Bank of America show.

“Yes, the Fed is tapering, but the Fed is still buying, which means their balance sheet is still expanding and as long as that's the case, the risks for inflation remain higher,” said David Leduc, the chief investment officer at Standish Mellon Asset Management Co., which manages $160 billion. Right now, Treasuries have “no value.”

(Bloomberg News)


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