In the U.S. bond market, the new normal is looking a lot like the old normal.
Interest-rate derivatives show traders anticipate economic growth that fails to spark runaway inflation even as global food and energy prices soar and the
Federal Reserve pumps $600 billion into the financial system by purchasing bonds. Based on where they see 10-year swap rates in a decade, the cost to lock in fixed rates in exchange for floating interest payments is the same now as it was before the worst financial crisis since the Great Depression.
For DoubleLine Capital LP in Los Angeles, which oversees $8 billion, the worst is over for the sell-off that drove 10-year Treasury yields as high as 3.77 percent this month from 2.33 percent in October. The notes yielded 3.53 percent as of 9:16 a.m. in New York.
“Ten-year yields have gotten to an appropriate level given the pace of the economic expansion and inflation expectations,” said Gregory Whiteley, a DoubleLine manager who says he would be a buyer if yields climbed to 4 percent for the first time since April. “Housing and stresses in state and local government finances will be a drag on growth. If yields moved over 4 percent it would attract demand from investors, including foreign central banks.”
The class of investors that includes foreign central banks bought a record 71 percent, or $17 billion, of the $24 billion in 10-year notes sold by the government in its latest auction on Feb. 9, according to the Treasury Department.
‘New World'
“Unless you think we are in a completely new world, which some people do, the inflation-adjusted forwards show that we are right back into the middle of the range that existed since the mid 1990s,” Dominic Konstam, New-York based head of interest- rate research at
Deutsche Bank AG, said in a telephone interview.
Forward contracts on interest-rate swaps that allow investors to lock in fixed-rate payments for 10 years a decade from now have risen to 5.31 percent, or where they were before the collapse of Lehman Brothers Holdings Inc. deepened the financial crisis in 2008. When adjusted for so-called core inflation, they're back to 2004 levels,
Deutsche Bank data show.
Even if consumer prices excluding food and energy costs were to triple this year from January's 0.2 percent increase, the so-called 10-year, 10-year forward rate would only fall to about 3.5 percent, within the top end of its range back through 2005, according to Deutsche Bank.
The 10-year note's yield will end the year at 3.75 percent, after first falling to 3.5 percent in the second quarter, according to the bank. The median estimate of 64 economists surveyed by Bloomberg is 3.93 percent at year-end.
Pimco's View
Bill Gross, who runs the world's biggest bond fund at Pacific Investment Management Co., reduced his holdings of government related debt to the lowest level since January 2009 while saying low yields cheat investors. Gross cut the proportion of U.S. government and related securities in Pimco's $239 billion Total Return Fund to 12 percent of assets in January from 22 percent in December, according to the Newport Beach, California-based company's website.
Policy makers are robbing savers by driving down real interest rates as they keep borrowing costs at record lows in a “devil's bargain,” Gross wrote in his monthly investment commentary on Feb. 2. He advised investors to reduce holdings of Treasuries and U.K. gilts and buy higher-returning securities such as debt from emerging-market nations.
Mohamed El-Erian, who serves as co-chief investment officer with Gross at Pimco, coined the term “new normal” to describe what he forecasts is an era of prolonged below-average global economic growth and investment returns.
Commodities Soar
Government bond yields have risen as prices of commodities from oil to wheat surged. Higher demand in emerging-market countries, drought in Russia and China, and flooding in Australia have sent corn futures up 95 percent in the past year, while wheat jumped 71 percent and soybeans advanced 44 percent. Snows in North America drove heating oil contracts up 32 percent.
The World Bank's food-price index climbed 15 percent between October and January, and President Robert Zoellick said on Feb. 16 that rising food prices have been an “aggravating factor” in the unrest in Africa and the Middle East. The gauge is 3 percent below its 2008 peak, when surging costs sparked riots in more than a dozen countries.
Fed policy makers don't expect increases in commodity prices to filter into broader inflation permanently, according to the minutes from the Jan. 25-26 Federal Open Market Committee meeting released last week.
‘Highly Visible'
While prices of some “highly visible” items such as gasoline have “significantly” increased, “overall inflation remains quite low” and wage growth has slowed, Fed Chairman Ben S. Bernanke said in a Feb. 3 speech at the National Press Club in Washington.
The five-year, five-year forward breakeven rate the Fed uses to chart investor expectations for future inflation has fallen to 2.77 percent from a 10-month high of 3.28 percent reached in December. The rate averaged 2.71 percent in the five years before the beginning of the financial crisis.
The difference between five- and 30-year Treasury yields widened to a record 3.04 percentage points in November amid speculation the Fed would concentrate its debt purchases on medium-maturity notes and the stimulus would ultimately result in quicker inflation. The spread has since narrowed, ending last week at 2.41 percentage points.
‘Off Base'
“Bernanke is not only off base with regard to inflation he's off the entire planet,” said Michael Pento, senior economist at Euro Pacific Capital Inc. in New York, who correctly predicted the 2008 commodity-market collapse. “Inflation will go much higher. You can't continue to have a reckless monetary policy and a government issuing endless quantities of debt and also have the supposition that you have the world's reserve currency and low interest rates.”
Treasuries lost 2.67 percent last quarter even after reinvested interest, and are down 1 percent this year,
Bank of America Merrill Lynch index data show. That compares with a return of about 6.79 percent for the Standard & Poor's 500 Index in 2011. Treasuries gained 5.88 percent in 2010.
Longer-term Treasuries are “at an inflection point and may now be driven more by President Barack Obama's handling of the deficit,” Scott Graham, head of government bond trading at Bank of Montreal's
BMO Capital Markets unit in Chicago, said in an interview in New York on Feb. 14.
Obama Interest
Increased demand for longer-maturity debt would aid the Obama administration as it loses the advantage of record low interest rates to finance cumulative deficits of more than $4 trillion through the end of 2015. Interest expense will rise to 3.1 percent of gross domestic product by 2016 from 1.3 percent last year, according to administration estimates.
Unemployment has remained at 9 percent or higher since May 2009, the longest stretch since the Labor Department began providing the statistics in 1948. The so-called underemployment rate -- which includes part-time workers who'd prefer a full- time position and people who want work but have given up looking -- was 16.1 percent in January.
American wages, which increased 1.7 percent on an average hourly basis last year, have acted as a constraint on inflation and buffered gains in households spending.
“U.S. inflation runs on wages, period,” and workers pay and benefits have declined, Brian Belski, chief investment strategist in New York for Oppenheimer & Co., said in a telephone interview. “Until we start to see expansive and robust job growth we are still several quarters away from any kind of semblance of wage inflation. Yields on the 10-year note will settle somewhere south of 4 percent.”
--Bloomberg News--
