Treasuries Gain on Speculation Fed Won't Raise Rates This Year

By Dakin Campbell

Aug. 16 (Bloomberg) -- Treasuries gained, driving yields on two-year notes close to a three-month low, as falling commodity prices and a strengthening dollar spurred speculation the Federal Reserve won't raise interest rates this year.

Ten-year notes gained for a third straight week as central bank policy makers said in speeches and interviews the economy is unlikely to improve soon. Reports showed sales at U.S. retailers dropped in July for the first time in five months. The euro zone's economy contracted for the first time since the European common currency debuted in 1999.

``The focus has shifted from being concerned about inflation to the global growth story,'' said Kurush Mistry, an interest-rate strategist at Lehman Brothers Holdings Inc. in New York, one of the 19 primary dealers that trade with the central bank. ``If commodities keep coming down, the market will be less concerned about inflation and more sanguine about the fact that the Fed doesn't need to be as hawkish'' against rising prices.

The yield on the two-year note fell 12 basis points, or 0.12 percentage point, this week to 2.39 percent in New York, according to BGCantor Market Data. It touched 2.31 percent, close to the lowest since May 21. The price of the 2.75 percent security due in July 2010 rose 7/32, or $2.19 per $1,000 face amount, to 100 22/32.

The 10-year note's yield dropped 10 basis points this week to 3.84 percent. It touched 3.82 percent, the lowest since July 16. Yields on 30-year bonds fell 7 basis points to 4.46 percent.

Treasuries remained higher even after a report showed consumer-price growth quickened in July more than expected. The Standard & Poor's 500 index rose 0.2 percent on the week.

`Extremely Sluggish'

Investors bought bonds as credit-market losses widened after JPMorgan Chase & Co. said Aug. 12 it will write down the value of mortgage-backed assets by at least $1.5 billion this quarter and UBS AG forecast ``adverse economic and financial trends'' will continue this year.

Chicago Fed President Charles Evans said yesterday in a speech at Bloomington, Illinois the, second half will ``likely be extremely sluggish'' and inflation should ease ``over the medium term.'' Other Fed policy makers said this week the worst for the U.S. may still be ahead as bank losses mount and credit conditions tighten.

Consumer spending at U.S. retailers in July fell 0.1 percent from a month earlier, the Commerce Department said Aug. 13. Home seizures by banks rose the most since reporting began in 2005, RealtyTrac Inc. of Irvine, California, said.

`Not a Lot of Places'

``There's not a lot of places to go to feel safe with your money,'' said James DeMasi, a fixed-income strategist at brokerage Stifel Nicolaus & Co. in Baltimore. ``The Treasury market still provides that.''

Mortgage finance company Fannie Mae's 30-year bond yields yielded 5.96 percent yesterday, 2.12 percentage points more than 10-year Treasuries, according to data compiled by Bloomberg. That's 26 basis points from the 22-year high of 2.38 percentage points on March 6, about a week before the Fed helped bail out Bear Stearns Cos.

Traders boosted bets the Fed will leave its target rate for overnight lending between banks at 2 percent through December, futures contracts on the Chicago Board of Trade showed. The likelihood yesterday was 74 percent, compared with 62 percent a week earlier and 49 percent a month earlier.

The dollar advanced 1.8 percent against the currencies of six trading partners as the euro region's economy weakened.

Ten-year Treasuries yield less than the annual rate of inflation by close to the most since 1980. The so-called real yield is now a negative 1.8 percentage points.

Falling commodity prices have stoked speculation the global economy will weaken enough to cap inflation. Crude oil futures have declined 24 percent from a record $147.27 a barrel on July 11. The Reuters/Jefferies CRB Index of 19 raw materials has dropped 20 percent from its July 2 peak.

`Shift in Fed-Speak'

``We've had commodities come off a little bit, and we've had a reasonably significant shift in Fed-speak,'' said Ian Lyngen, an interest-rate strategist in Greenwich, Connecticut, at RBS Greenwich Capital, another primary dealer.

Minneapolis Fed President Gary Stern warned last month of inflation, and Dallas Fed President Richard Fisher dissented at the central bank's Aug. 5 decision to keep rates unchanged. Both have since said the economy is weakening.

Treasuries also gained this week as a portion of more than $43 billion in government debt maturing yesterday reentered the market. They included issues of three-, five-, and 30-year securities, according to the Treasury Department.

Net purchases of Treasury notes and bonds by foreign investors increased $28.3 billion in June, compared with $5.7 billion a month earlier, the Treasury Department said.

To contact the reporter on this story: Dakin Campbell in New York at dcampbell27@bloomberg.net