By Deborah Levine
Yields on U.S. Treasury bonds will rise from their current
near-record lows by the end of the year as economic growth resumes,
but are likely to stay at historically depressed levels, the
biggest bond dealers say.
Additional debt supply to stimulate the economy may also
conspire to push yields higher, as some say issuance could reach $2
trillion in fiscal 2009.
Still, bond dealers surveyed by MarketWatch acknowledge
unusually high uncertainty about when the economy will start to
turn around, clouding the timing and the extent of the expected
rebound in yields.
"Ultimately, we expect rates to go higher as the economy starts
to recover through 2009," said James O'Sullivan, economist at UBS,
one of the 17 primary government security dealers.
Investors rushed into Treasurys in 2008, pushing yields to
all-time lows last month. Rising yields could mean anyone who
continues to hold onto their bonds could see big losses.
Two-year note yields (UST2YR) are forecast to rise to 1.11% by
the end of the year, from 0.75%, according to the median estimate
of the 16 of the dealers surveyed.
Ten-year yields (UST10Y) will increase to 3.01% from 2.38%
currently. Such a rise, while notable, would mean that benchmark
debt still yields less than it had for most of the prior five
decades.
Primary dealers are firms that trade directly with the New York
branch of the Federal Reserve and are required to bid at Treasury
auctions. Their ranks have shrunk in the last year, as Bear Stearns
and Countrywide got bought by other dealers and Lehman Brothers
(LEHMQ) went bankrupt.
For the first three months of 2009, yields are expected to
remain near current levels as fears about the depth of the
recession overshadow investors' willingness to move money away from
the relative safety of U.S. government debt.
On Friday, the Labor Department said the U.S. unemployment rate
jumped to 7.2% last month, the highest in 16 years. In all of 2008,
2.6 million Americans lost their jobs, the most in a year since
World War II.
"Treasury yields have gone to such a low level because we're in
a dismal economic situation," said Michael Moran, an economist at
primary dealer Daiwa Securities. "When we start to see any sign of
improvement, we'll see Treasury yields increase."
He predicts two-year yields will end the year at 1.60% while
10-year notes yield 2.90%.
How much debt?
Besides a change in the economic picture, dealers site the
tsunami of Treasury issuance expected to hit the market as the
government finances programs to revive financial markets and spark
economic growth.
Already, the government has invested in all the major financial
institutions, as well as extended multi-billion dollar loans to
insurer American International Group (AIG), and automaker General
Motors (GM). Also, the Fed has started buying mortgage-backed
securities and debt issued by the big home-finance agencies,
including Fannie Mae (FNM) and Freddie Mac (FRE).
President-elect Barack Obama is expected to announce a plan soon
after he takes office that entails around $800 billion of spending
and tax cuts.
Bond analysts and investors worry about pressures on the
government to borrow more because more debt issuance tends to
reduce the value of current holdings, pushing yield up.
"We expect supply to nearly double again" as it did from 2007 to
2008, said Michael Pond, Treasury strategist at Barclays Capital.
The credit crisis enabled demand for Treasurys to keep up with
supply last year, but he doesn't expect that to repeat.
"Supply should go up and demand should go down as we see the
reverse of the flight to quality into the Treasury market," Pond
said.
Barclays expects issuance of notes and bonds to reach $1
trillion in fiscal 2009, which began in October.
Whether investors will make that rush out of Treasurys, or from
cash to other assets including equities, commodities or corporate
bonds, is very much debated. After 2008's multiple false-starts and
predictions that the crisis is contained, investors may be shaken
enough to stay in Treasurys until they see really solid improvement
in the economy.
The market is being premature in thinking we'll be out of the
woods," said Steven Ricchuito, chief economist at primary dealer
Mizuho Securities. "Investors have just been burned, so where do
you think they are going to put their savings money?"
Other factors that may limit the increase in Treasury yields,
especially on longer-term debt, are expectations that inflation
will remain low for some time amid a sluggish global economy.
Higher inflation erodes the value of fixed income payments, so
concerns that prices will rise cause investors to demand higher
yields.
The gap between yields on regular 10-year notes and Treasury
Inflation Protected Securities, which represents the rate of
inflation in the $524 billion market, is now about 0.37 percentage
point. That means investors are pricing the securities as if
inflation in the next 10 years will average 0.37%. These bonds pay
investors a coupon rate plus the rate of inflation.
"We're in a very benign inflation environment on top of a weak
growth," said Drew Matus, U.S. economist at Merrill Lynch. "As
demand falls, it puts downward pressure on prices."
He expects U.S. gross domestic product to decline 2.8% in 2009,
and says Treasury yields will set new lows by the end of the year.
Two-year yields will drop to 0.40% and 10-year notes will yield
1.50%, according to Merrill.
"As risks emerge across different asset classes, there should be
significant demand for Treasurys even at very low yields," Matus
said.
-Deborah Levine; 415-439-6400; AskNewswires@dowjones.com
Click here to go to Dow Jones NewsPlus, a web front
page of today's most important business and market news, analysis
and commentary. You can use this link on the day this article is
published and the following day.