Treasuries Beating U.S. Assets Vindicate Bernanke, Not Gross

By Sandra Hernandez and Daniel Kruger

Sept. 8 (Bloomberg) -- Maxwell Bublitz got a lot of grief when he said Treasuries would rebound from the worst bear market in four years as inflation abated and economic growth slowed.

``People over the last five months have been saying, `you're out of your mind,''' said Bublitz, 53, who oversees $3.5 billion in fixed-income assets as the chief strategist at San Francisco-based SCM Advisors LLC.

While Bublitz predicted on June 25 that two-year notes would gain, Bill Gross of Pacific Investment Management Co., Colin Lundgren at RiverSource Institutional Advisors, and Thomas Atteberry of First Pacific Advisors, who together run about $1 trillion, said the slump would worsen. They cited surging commodity prices and the minimal assurance offered by Federal Reserve Chairman Ben S. Bernanke that inflation would slow.

Instead, U.S. debt of all maturities returned 2.6 percent since June 30 as crude oil tumbled 27 percent from a record high and the credit crisis that followed the collapse of the subprime-mortgage market entered its second year. So far this quarter, Treasuries beat the returns of 2 percent on debt sold by AAA-rated corporations and the 1.7 percent gain on government-sponsored agencies, according to indexes compiled by Merrill Lynch & Co. The Standard & Poor's 500 Index slumped 2.5 percent in the same period.

The rebound provides some vindication for Bernanke, who cut the Fed's target rate for overnight loans seven times to 2 percent to keep the economy growing even as commodities had their best first half in 35 years and inflation soared to a 17- year high. Bublitz says tumbling oil prices, a slumping housing market and $507.1 billion in credit-related losses will send two-year yields to 2 percent within two months.

Second-Quarter Slump

Yields on the benchmark notes maturing in August 2010 fell 11 basis points to 2.24 percent last week, according to BGCantor Market Data. They last dropped below 2 percent on April 17. The price of the 2.375 percent security rose 7/32, or $2.19 per $1,000 face value, to 100 1/4.

As recently as June, investors dumped Treasuries on expectations that quickening inflation would prompt the Fed to raise rates, eclipsing concern that five straight months of job losses and a 15 percent decline in home prices would drag the economy into a recession. U.S. debt of all maturities lost 2.1 percent in the second quarter, the worst slump since 2004.

Treasuries rebounded in July and August as shares of Fannie Mae and Freddie Mac, which own or guarantee about 42 percent of the $12 trillion in U.S. home loans, plunged on concern they lacked the capital to survive the worst housing slump since the Great Depression.

Treasury Secretary Henry Paulson decided to take control of Fannie and Freddie after review found the beleaguered mortgage- finance companies used accounting methods that inflated their capital, according to people with knowledge of the decision.

`Two Steps Back'

Wan-Chong Kung, who helps oversee $76 billion in bonds as a fund manager at FAF Advisors in Minneapolis, the asset- management arm of U.S. Bancorp, is less inclined to sell Treasuries during rallies as she comes to grips with the halting nature of the recovery.

``It continues to be a case of one step forward, two steps back,'' Kung said. ``As the financial market mess remains alive and with us, the need and desire for quality and safety and Treasuries continues.''

Gross, who said Treasuries were ``overvalued'' in a July 21 interview because their yields were too low, still prefers agency debt. Even so, he called for the U.S. government to start using more of its money to support markets to stem a burgeoning ``financial tsunami'' in a commentary posted on Newport Beach, California-based Pimco's Web site on Sept. 4.

Pimco and other large investors may put in their own money into agency debt once the Treasury decides to inject government funds, Gross said Sept. 5 in a Bloomberg Television interview.

`Still Too Low'

``Over the last six weeks it has gotten into people's minds that the credit crisis is not over yet,'' said Jamie Jackson, who oversees government debt trading at Minneapolis-based RiverSource. His colleague Lundgren wasn't available for comment.

Jackson still finds Treasuries too expensive. Ten-year notes yield 1.8 percentage points less than the inflation rate, the lowest so-called real yield since 1980.

``There's a growing consensus the economy's gotten weaker,'' said First Pacific's Atteberry. That said, ``yields are still too low'' to buy Treasuries. Government debt has gained because ``people are still fearful of problems in the financial system and that's given them a flight to quality.''

The Treasury plans to put Fannie and Freddie into a so- called conservatorship and pump capital into the companies, House Financial Services Committee Chairman Barney Frank said in an interview on Sept. 6.

Insurance Policy

Traders' expectations for inflation over the next decade fell to a five-year low last week, yields on Treasury Inflation Protected Securities show. TIPS due in 10 years yielded 1.97 percentage points less than notes of similar maturity, the smallest gap since 2003. The difference reflects the average inflation rate expected over the life of the securities. Oil fell to a five-month low of $105.13 on Sept. 5 on speculation slowing growth will curb demand.

Payrolls fell in August for an eighth month, by 84,000, the Labor Department said Sept. 5.

``It's just drip, drip, drip,'' said Bublitz, who is profiled in the 2000 book ``When Genius Failed'' as one of the first money managers to resist investing in the failed hedge fund Long Term Capital Management while head of Conseco Capital Management Inc. in the 1990s. ``While most people aren't there yet, they're saying, `as an insurance policy maybe I should own more Treasuries.'''

To contact the reporter on this story: Sandra Hernandez in New York at shernandez4@bloomberg.net; Daniel Kruger in New York at dkruger1@bloomberg.net