Treasuries' Worst Performance Since 2004 Makes Rebound Unlikely

By Daniel Kruger

June 30 (Bloomberg) -- The biggest bear market in Treasuries since 2004 may get worse.

Unlike four years ago, when Federal Reserve Chairman Alan Greenspan embarked on 17 consecutive interest-rate increases to contain the threat of rising consumer prices, his successor Ben S. Bernanke is giving investors few assurances that the scourge of inflation will abate anytime soon.

``The Treasury market going forward is more an inflation story,'' said Colin Lundgren, head of institutional fixed income for RiverSource Institutional Advisors in Minneapolis, which manages $100 billion in bonds. RiverSource is reducing Treasuries in favor of securities backed by commercial mortgages and investment-grade corporate debt, he said.

Investors have lost 2.88 percent on average since March, including reinvested interest, according to Merrill Lynch & Co.'s Treasury Master Index. That's the worst performance since the second quarter of 2004, when they tumbled 3.1 percent.

Based on past years when the Fed, like now, was grappling with faster inflation and concern about turmoil in credit markets was starting to ease, investors might not enjoy a rebound.

In the second halves of 1994 and 1999, U.S. government debt returned less than 1 percent. In the first case the Fed increased interest rates in response to inflation threats, while in 1999 the collapse of hedge fund Long-Term Capital Management LP the year before failed to bring down the economy.

Slump Interrupted

As recently as June 23 Treasuries were down 3.27 percent for the quarter, the most since the three months ended Sept. 30, 1980, when they tumbled 5.1 percent. Back then, Fed Chairman Paul Volcker was raising rates to stamp out inflation.

Treasuries then recovered some of their losses as the Fed ended the most aggressive series of rate cuts in two decades and gave no indication that it will soon raise borrowing costs. That caused traders to pare bearish bets they placed in anticipation that policy makers would be more hawkish.

``Investors believe that future moves by the Fed are likely to be tightenings rather than easings,'' said Jane Caron, chief economic strategist in Burlington, Vermont, at Dwight Asset Management Co. The firm oversees $70 billion of bonds.

The yield on the 2.875 percent note maturing in June 2010 fell 27 basis points last week to 2.63 percent, according to BGCantor Market Data. The yield on the benchmark 10-year Treasury, a 3.875 percent note due in May 2018, dropped 20 basis points to 3.97 percent.

Cutting Back

Even with the rally, managers overseeing $1.37 trillion cut their holdings of Treasuries to 30 percent of assets on June 27 from 34 percent two weeks earlier, according to a survey by Jersey City, New Jersey-based Ried, Thunberg & Co.

Changing sentiment among investors can be seen in two-year notes, which are more sensitive to expectations for monetary policy than longer-maturity debt.

Yields climbed to 104 basis points above the Fed's target rate for overnight loans between banks this month from 190 basis points below at the start of the year. The spread, which ended last week at 63 basis points, has averaged 23 basis points, or 0.23 percentage point, this decade.

``The Committee expects inflation to moderate later this year and next year,'' the Fed said in a statement on June 25. ``However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high.''

`Upward Drift'

American consumers, as well as investors such as Thomas Atteberry of First Pacific Advisors, are less optimistic than Fed officials. They anticipate average annual inflation of 3.4 percent over the next five years, the highest expectation since 1995, according to the Reuters/University of Michigan survey. The consumer price index increased 0.6 percent in May, the most since November, the Labor Department said June 13.

``I'm not convinced they're going to see the sort of inflation moderation they're hoping for,'' Atteberry, who manages $3.5 billion in fixed income assets for First Pacific in Los Angeles, said of the Fed. ``You will continue to see the upward drift in Treasury rates.''

U.S. government debt fell 3.35 percent in 1994 as the central bank raised rates to 5.5 percent from 3 percent to prevent the economy from entering an inflationary expansion. Consumer prices had climbed 2.5 percent in the 12 months ended in February 1994, when the Fed began boosting its target.

And in 1999 Treasuries lost 2.38 percent as Greenspan boosted rates three times, to 5.5 percent from 4.75 percent. Inflation was 2 percent at the time of the first increase. The tightening reversed three cuts in 1998 intended to revive confidence in credit markets shaken by the collapse of Greenwich, Connecticut-based Long-Term Capital.

Bernanke Versus Greenspan

Bernanke lowered rates seven times between September and April, to 2 percent from 5.25 percent as the subprime mortgage market collapsed. Now, traders see an 86 percent chance the Fed will lift rates to 2.25 percent or more by year-end, futures contracts on the Chicago Board of Trade show. One month ago the odds of an increase were 15 percent.

When Greenspan began to boost borrowing costs in 2004, lifting the target rate to 5.25 percent in 2006 from 1 percent, Treasuries gained 3.5 percent as investors bet the moves were sufficient to contain inflation. Consumer priced had increased 3.3 percent in the 12 months ended in June 2004.

Bernanke isn't inspiring the same confidence, though he presided over the last three increases in 2006. That's because the economy isn't rebounding. The Commerce Department said last week the economy grew at a 1 percent annual pace in the first quarter, capping the weakest six-month expansion in five years.

Consumer, Producer Prices

Consumer prices climbed 4.2 percent in the 12 months to May, while producer prices jumped 7.2 percent during the same period. The Reuters/Jefferies CRB Index has gained 48 percent in the past year, compared with an increase of 14 percent in the 12 months ended June 2004.

Inflation expectations as measured by difference in yields between 10-year Treasury Inflation Protected Securities, or TIPS, and conventional notes are rising. The so-called breakeven rate was 2.53 percentage points on June 27, up from this year's low of 2.20 percentage points on Jan. 22.

``The Fed will talk tough but actions speak louder than words and they're not going to act,'' said Richard Schlanger, a money manager at Pioneer Asset Management in Boston, which oversees $44 billion in fixed income. ``I just can't see the Fed tightening at this point. The economy's too weak, the financial system still is in jeopardy, you've got unemployment rising.''

To contact the reporter on this story: Daniel Kruger in New York at dkruger1@bloomberg.net