Bernanke Push for Lower Rates Drives U.S. Yields Up

By Sandra Hernandez and Wes Goodman

Nov. 3 (Bloomberg) -- Even as Ben S. Bernanke cuts borrowing costs to 50-year lows, taxpayers will likely be paying ever increasing interest rates on U.S. debt.

The next president may find foreign investors, the biggest creditors to the U.S., unable to absorb a growing supply of Treasury bonds as the financial crisis prompts nations to invest in their own banks and currencies. That would drive up yields just as a widening budget deficit pushes borrowing needs to a record $2 trillion, according to estimates by Goldman Sachs Group Inc. and Wrightson ICAP LLC.

``It's hard to see how demand for Treasuries is going to keep up with supply once the risk aversion trade subsides,'' said Tony Norris, who oversees $10 billion in international strategies as chief investment officer and senior portfolio manager at Evergreen International Advisers in London. ``There's going to be pressure on yields to rise.''

Treasury Secretary Henry Paulson may already be overwhelming investors with short-term obligations sold to finance the initial portion of a $700 billion bailout package.

Rates on six-month bills rose last month to 0.56 percentage point more than the December futures contract for the Federal Reserve's target rate for overnight loans between banks. The gap was the largest in at least 20 years and compares with an average of minus 0.09 percentage point.

Keeping Rates Low

Yields rose even as the Fed slashed its target rate to 1 percent from 2 percent, and San Francisco Fed President Janet Yellen said policy makers may bring the benchmark closer to zero. Banks and financial institutions around the world have taken about $855 billion in writedowns and losses since the start of 2007 as subprime mortgage defaults in the U.S. infected the global economy, according to data compiled by Bloomberg.

Two-year note yields ended last week at 1.57 percent, up from the month's low of 1.32 percent on Oct. 8, while 10-year notes climbed to 3.97 percent from 3.4 percent. Treasuries were little changed today as of 10:33 a.m. in Singapore.

The Treasury will announce its quarterly borrowing needs on Nov. 5. The U.S. may sell a net $388 billion of bills, notes and bonds this quarter, up from $178.4 billion last quarter and $33.4 billion in the same period of 2007, according to a quarterly survey by the Securities Industry and Financial Markets Association released Oct. 31.

``This year's financing needs will be unprecedented,'' Anthony Ryan, the Treasury's acting undersecretary for domestic finance, said Oct. 28 at a Sifma conference in New York.

Foreign Demand

For much of this decade, the U.S. has been able to count on foreign investors and central banks to funnel a growing pile of reserves into Treasuries. Investors outside the U.S. hold $2.74 trillion of Treasuries, or 52 percent of the $5.22 trillion in marketable debt outstanding, according to the government. That's up from $1.09 trillion, or 33 percent, in 2000.

U.S. long-term interest rates would be about 1 percentage point higher without foreign government and central bank buyers, according to Professors Francis and Veronica Warnock at the University of Virginia in Charlottesville, who have performed research on the subject for the Fed.

Foreign official purchases of Treasuries fell by more than half in August, to a net $4.8 billion, from $10.1 billion in July, and an average of $7.5 billion in the preceding 12 months, according to the Treasury Department. Japan, the top holder, sold a net $7.5 billion.

U.S. `Needs Help'

``The U.S. Treasury Secretary is trying to convince other countries, including China and Japan, to buy its government bonds,'' said Shen Jianguang, a Hong Kong-based economist at China International Capital Corp., the nation's biggest stock underwriter. ``This is the first time a developed country needs help from developing countries to ride out its crisis.''

Treasury spokeswoman Jennifer Zuccarelli declined to comment.

The International Monetary Fund's World Economic Outlook forecast last month that global growth will weaken to 3 percent in 2009, from 3.9 percent this year and 5 percent in 2007. That would mean a world recession under the fund's definition.

``Some of these foreign governments now are a little bit worried they need to prop up their own financial systems and potentially deal with their own deficits, so taking the money and shipping it off to the U.S. isn't as attractive as it used to be,'' said Jamie Jackson, who oversees government and agency debt trading at RiverSource Investments. The Minneapolis-based firm manages $93 billion of fixed-income assets.

France, Germany, Spain, the Netherlands and Austria committed $1.8 trillion to guarantee bank loans and take stakes in their lenders.

`Never Disappear'

Nations such as Japan, China, and Saudi Arabia still have incentives to buy Treasuries because the securities serve as a repository for their dollar reserves. China's foreign-exchange reserves rose to $1.91 trillion in September, the most of any nation.

``Demand will never disappear -- they have to manage their foreign reserves,'' said Tsutomu Komiya, an investment manager in Tokyo at Daiwa Asset Management Co., a unit of Japan's second-largest brokerage. Still, ``everyone is talking about supply. Yields will tend to go up,'' he said.

Demand for U.S. government securities soared in September as the bankruptcy of Lehman Brothers Holdings Inc. drove investors to the relative safety of government debt. Rates on three-month bills plunged to 0.02 percent, the lowest since the 1940s, and 10-year note yields declined to a five-year low of 3.246 percent.

Fleeing Risk

At the same time, the three-month London interbank offered rate in dollars, or the rate banks charge each other for loans, soared to 4.82 percent on Oct. 10 from 2.82 percent on Sept. 15. The extra yield investors demand to own investment-grade U.S. corporate bonds instead of Treasuries rose to a record 6.18 percentage points last week, according to Merrill Lynch & Co.'s U.S. Corporate Master Index.

Last week's rise in yields suggests efforts by governments and central banks to bolster confidence may be working, alleviating the need for Treasuries. The Treasury has sold $755 billion in bills this year outside of its regularly-scheduled sales to support bank-lending programs.

Three-month Libor fell to 3.03 percent last week from 4.82 percent on Oct. 10. Corporate borrowing in the U.S. commercial paper market surged the most on record after the Fed began buying the debt directly from issuers, pushing rates on overnight debt to 0.35 percent, the lowest ever.

Three-Year Note

At current sizes, Treasury's sales of notes and bonds would raise less than one-fifth of the $1.95 trillion the government may need to borrow in fiscal 2009, according to Jersey City, New Jersey-based Wrightson, which specializes in government finance. The U.S. has sold about $687 billion in notes and bonds this year, almost 20 percent more than in all of 2007.

Treasury said last month it will expand auctions. It already said it may revive sales of three-year note and hold more frequent sales of 10- and 30-year securities.

While central banks will continue to show ``good participation'' in the Treasury market, ``the sheer magnitude of the amount of money the U.S. is going to have to borrow means that yields will likely go higher,'' said Richard Bryant, a Treasury trader at New York-based Citigroup Global Markets Inc., one of the 17 primary dealers required to bid at Treasury sales. ``The numbers are staggering.''

One result is the next president will face bigger deficits than any predecessor.

`Sharp Sell-Off'

The totals may be bigger under Barack Obama than John McCain because the Democratic presidential nominee is more open to spending on programs such as infrastructure, said Mitchell Stapley, who oversees $22 billion as chief fixed-income officer at Fifth Third Asset Management in Grand Rapids, Michigan.

``Grading on a scale of 0 to 100 -- 0 being less supply, 100 being a whole lot more supply -- both candidates are both probably 75 and above,'' he said.

Obama, 47, leads Republican presidential nominee McCain, 72, by an average of 6.9 percentage points in national polls. Polls released this week showed the Democratic candidate with leads ranging from three points in a Fox News survey to 13 points in a CBS News poll.

``At some stage, such a large increase in issuance may lead to a sharp sell-off in U.S. Treasuries and the U.S. dollar,'' said Shinji Kunibe, a senior money manager who helps oversee $847 billion globally at the Tokyo branch of JPMorgan Asset Management.

To contact the reporter on this story: Sandra Hernandez in New York at shernandez4@bloomberg.net; Wes Goodman in Singapore at wgoodman@bloomberg.net.