Treasuries Post Biggest Gain Since June as U.S. Economy Slows

By Daniel Kruger

Aug. 2 (Bloomberg) -- Treasuries posted the biggest weekly gains since June as government reports showed the economy slowing and employment falling, adding to expectations that the Federal Reserve won't raise interest rates this year.

The difference in yields between two- and 10-year notes, known as the yield curve, increased 5 basis points to 1.44 percentage points, indicating investors are concerned that the central bank may not be able to contain inflation even as the economy slows. Futures indicate there's a 93 percent probability that policy makers will leave borrowing costs unchanged when they meet next week.

``Given all the other stresses out there, there's not much of a case for the Fed to hike,'' said Carl Lantz, an interest- rate strategist in New York at Credit Suisse Securities USA LLC, one of 19 primary dealers that trade with the Fed. ``At the same time, it's hard to cut until we get more clarity on the direction of inflation.''

Two-year note yields fell 22 basis points, the most since the week ended June 27, to 2.49 percent. The price of the 2.75 percent security due in July 2010 rose 13/32 for the week, or $4.06 per $1,000 face amount, to 100 1/2, according to BGCantor Market Data.

Yields on the 10-year Treasury note declined 17 basis points, also the most since the week ended June 27, to 3.93 percent. A basis point is 0.01 percentage point.

Payrolls shrank by 51,000 jobs in July, the Labor Department said yesterday. While the decline was less than the 75,000 forecast in a Bloomberg News survey of economists, it was the seventh consecutive monthly drop. The unemployment rate rose last month to 5.7 percent, the highest since March 2004.

Possible Recession

``The report was consistent with a deteriorating labor market and a weak fundamental economy,'' said Stuart Spodek, co- head of U.S. bonds in New York at BlackRock Advisors Inc., which manages $527 billion in debt.

A Commerce Department report on July 31 showed economic growth slowed more than forecast, and revisions to earlier reports suggested the economy may have slipped into recession during the last three months of 2007.

Gross domestic product grew at an annualized rate of 1.9 percent in the second quarter. The median forecast in a Bloomberg survey of economists was 2.3 percent. The report's annual revisions lowered the growth rate back to 2005 and showed GDP contracted 0.2 percent in the last three months of 2007.

The Labor Department also said on July 31 that jobless claims hit a five-year high last week.

`Really Tight Spot'

``The Fed is in a really tight spot,'' said Richard Schlanger, a portfolio manager at Pioneer Investments in Boston, which oversees $44 billion in fixed income. Weakness in the economy ``is so apparent, and yet they've already provided so much accommodation to bolster the weak financial system.''

Futures contracts on the Chicago Board of Trade yesterday showed a 37 percent chance the Fed will leave its benchmark rate for overnight loans between banks steady at its December meeting, compared with 12 percent a month earlier. The odds of an increase at its meeting Aug. 5 are 7 percent.

Interest-rate increases are very unlikely, as the central bank has ``clearly given us the signal they're worried about the financial system,'' said George Goncalves, chief Treasury and agency strategist with Morgan Stanley in New York, another primary dealer.

The central bank lowered its target rate for overnight lending between banks by 3.5 percentage points, to 2 percent, in a series of seven cuts that began in September.

`Fragile Circumstances'

It also extended two emergency lending programs to Wall Street firms until Jan. 30 ``in light of continued fragile circumstances in financial markets,'' it said on July 30. The Primary Dealer Credit Facility provides direct loans to securities firms and the Term Securities Lending Facility loans Treasuries. Both aim to boost liquidity in the financial system.

Financial firms worldwide have lost or written down $480 billion in connection with the credit crisis that began with rising delinquencies in subprime mortgages last year, data compiled by Bloomberg show.

The Treasury plans to auction $17 billion in 10-year notes Aug. 6 and $10 billion in 29 3/4-year bonds Aug. 7. The total is higher than analysts forecast and exceeds the $21 billion in notes and bonds sold in May. The government also is considering boosting the frequency of debt sales, it said this week.

The U.S. budget deficit will increase to a record $482 million next year, the Bush administration said on July 28.

`Bit of a Lid'

``We have to deal with the refunding this month, and that may put a bit of a lid'' on price gains, said Donald Ellenberger, who oversees about $6 billion as co-head of government and mortgage-backed securities at Federated Investors in Pittsburgh.

Treasuries have returned 2.6 percent so far this year after gaining 9.1 percent last year, according to Merrill Lynch & Co.'s Treasury Master Index.

Regular government debt outpaced Treasury Inflation Protected Securities, or TIPS, this week. Ten-year TIPS yielded 2.30 percentage points less than similar-maturity notes, near the narrowest since April 30, when the difference was 2.28 percent. The gap, known as the breakeven rate, indicates the inflation rate traders expect over the next decade.

U.S. consumer prices surged 5 percent in the past year, the biggest jump since 1991, the government said July 16. Some policy makers said at the Fed's June 25 meeting that a rate increase ``would be appropriate very soon,'' meeting minutes show.

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