Treasuries Irresistible as Deflation Trumps Paulson

By Daniel Kruger and Sandra Hernandez

Sept. 22 (Bloomberg) -- As details of Treasury Secretary Henry Paulson's plan to revive the U.S. financial system by pumping as much as $700 billion into the markets emerged Sept. 19, bond investor Michael Cheah was reminded of Japan.

When that country's real estate bubble burst, leaving a trail of bad real estate loans, officials flooded the economy with cash only to see banks hoard the money instead of lending it out. The result has been a series of recessions and persistent deflation for more than a decade.

``Although the government tried to debase the yen by printing a lot of government bonds, the economy went into a standstill,'' said Cheah, an official at the Monetary Authority of Singapore from 1991 to 1999 who manages $2 billion at AIG SunAmerica Asset Management in Jersey City, New Jersey. ``The banks used the money to buy safety. I see a repeat happening here. The banks will use it to buy Treasuries.''

While U.S. bonds tumbled on the plan to buy soured mortgage-related assets from financial institutions in the most far-reaching federal intrusion into markets since the Great Depression, they still ended the week little changed.

To investors such as Cheah, that's a clear sign the economy is facing many of the same risks that have afflicted Japan. The yield on the benchmark 30-year Treasury bond, which stands to benefit the most of any government maturity from a drop in inflation expectations, fell to 3.89 percent last week, the lowest level since the U.S. reintroduced the security in 1977.

`Same as Japan'

Only Japan offers inflation-linked bonds that pay lower rates than similar securities issued by the Treasury.

For maturities up to four years, the difference in yields between Treasury Inflation-Protected Securities and nominal bonds is 1 percentage point or less. The so-called breakeven rate represents the pace of inflation investors expect over the life of the securities.

``The current U.S. situation is the same as Japan's case,'' said Hiromasa Nakamura, senior fund investor at Tokyo-based Mizuho Asset Management Co., which oversees $36.5 billion as part of Japan's second-largest bank. ``The economic slowdown and credit crunch are creating a downward spiral.''

Nakamura, who correctly forecast the rally in Treasuries last year, said two-year note yields will fall to 1.1 percent by year-end, while the 10-year will decline to 3 percent.

The 2.375 percent note due August 2010 ended last week at 100 11/32 to yield 2.20 percent, while the 4 percent security maturing in August 2018 finished at 101 10/32 to yield 3.84 percent.

Two-year yields fell to 2.11 percent and the 10-year yield dropped to 3.78 percent as of 6:47 a.m. today in London.

Rate Expectations

Just last month, traders, concerned that rising food and energy costs were trickling into the broader economy, saw a 65 percent probability the Federal Reserve would raise borrowing costs by the end of 2008 to contain consumer prices. Now, there's a 100 percent chance its 2 percent target rate will either stay the same or be cut, futures on the Chicago Board of Trade show.

The Labor Department in Washington said last week that consumer prices fell 0.1 percent in August, the first decline in almost two years, as fuel costs dropped from record levels. The yield on the 10-year Treasury is 1.55 percentage points below the consumer price index, the most since 1980 and a sign that traders expect inflation to slow. The yield typically averages about 3.4 percentage points more than inflation.

Traders think ``they're looking at Japan,'' said Dominic Konstam, head of interest-rate strategy at Credit Suisse Securities USA LLC in New York, one of 19 primary dealers that trade with the Fed.

Far to Go

The U.S. has far to go before matching what Japan has gone through. Since 1995, inflation in the world's second-biggest economy after the U.S. has averaged zero percent, while growth has averaged 1.4 percent. The Bank of Japan maintained what it called a ``zero interest-rate policy'' from 2001 through 2006 to try to stimulate the economy.

The yield on Japanese inflation-linked debt maturing in 10 years averaged 0.59 percentage point since being introduced in April 2004 and is currently negative 0.21 percent. The comparable U.S. yield is 1.92 percent.

Rather than a decline in consumer prices, a more likely scenario is a slowdown in inflation, said Stewart Taylor, a senior investment-grade debt trader at Boston-based Eaton Vance Management, which oversees about $6 billion of taxable bonds.

``Do we move into full-blown deflation as opposed to disinflation? I doubt it,'' he said.

Seeking a Haven

Instead of a referendum on inflation, much of the rally in bonds may be tied to investors seeking a haven from financial market turmoil that led to the government's takeover of Washington-based Fannie Mae, Freddie Mac in McLean, Virginia, and American International Group Inc. of New York and the bankruptcy of New York-based Lehman Brothers Holdings Inc.

Some of that flight to safety was reversed Sept. 19 after Paulson and Fed Chairman Ben S. Bernanke announced a plan to buy troubled assets from financial institutions. The U.S. may have to borrow an extra $700 billion to $1 trillion to fund the rescue of the financial system, flooding bond investors with more supply, according to Barclays Capital Inc. interest-rate strategist Michael Pond in New York.

Bond bulls point to a still weakening housing market for why they expect inflation to slow and yields to remain low.

Home prices have plunged 19 percent on average from their peak in July 2006, according to the S&P/Case-Shiller index of 20 cities. Economists at New York-based Goldman Sachs Group Inc. said this month they expect prices to drop another 10 percent.

Cutting Back

Though consumer prices in the U.S. rose 5.4 percent in August from a year earlier, the Goldman economists noted it took almost four years ``from the bursting of the financial bubble in 1990 until prices first fell on a year-over-year basis'' in Japan.

The housing weakness is causing consumers to cut back on spending. The Labor Department in Washington said last week that new-vehicle prices dropped 0.6 percent in August, the most since November 2006, and hotel fares tumbled 1.1 percent.

``There are deflationary events out there and debt default is one of the primary drivers,'' said Jeffrey Gundlach, chief investment officer at Los Angeles-based TCW Group Inc., which oversees $90 billion in fixed-income. ``It's what they call a debt deflation cycle, and there's definitely one underway.''

The percentage of Treasuries in a diversified bond fund Gundlach manages is the highest it's ever been, he said.

The world's biggest banks have taken more than $500 billion in writedowns and losses on securities tied to subprime mortgages since the start of 2007, according to data compiled by Bloomberg. Almost a year ago, Goldman economists said just $400 billion of losses would cut banks' lending by $2 trillion.

``There's a huge amount of deflationary pressure when you get this kind of capital destruction,'' said Brian Edmonds, head of interest rates at Cantor Fitzgerald LP in New York, another primary dealer.

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