Bonds Show Lehman Fades In History as Spreads Narrow

By Dakin Campbell

May 4 (Bloomberg) -- From Frankfurt to London to New York to Tokyo, bond traders say the Lehman Brothers Holdings Inc. bankruptcy is fading into history as the cost of credit retreats throughout the Group of Seven industrialized nations.

The shock to financial markets from Lehman’s collapse in September sent the Standard & Poor’s 500 Index to its biggest annual decline since 1938, froze credit markets, drove Goldman Sachs Group Inc. to seek $5 billion from Warren Buffett and sparked a run on Treasuries that caused bill rates to fall below zero for the first time.

Now, the record pace of corporate bond sales, declining money market rates and a drop in mortgage costs all suggest the global economy is on the mend. In the government debt market, yields on 10-year notes exceed those of two-year securities by at least 1 percentage point in all the G-7 nations for the first time since before 1991, according to data compiled by Bloomberg. The so-called yield curve typically steepens when traders anticipate a recovery.

The gap “is likely to get steeper still,” said Paul McCulley, a managing director at Newport Beach, California-based Pacific Investment Management Co., which oversees the world’s biggest bond fund. “When policy stimulation gets traction in the real economy,” investors will begin to anticipate higher yields, he wrote in a May 1 e-mail.

Keeping Rates Low

Central banks show no inclination of raising interest rates until the housing market recovers, restraining short-term bond yields. Federal Reserve policy makers said March 18 that they are prepared to keep benchmark rates “exceptionally low” for “an extended period.” Bank of Canada Governor Mark Carney said he intends to leave the central bank’s main rate at a record low 0.25 percent until the end of June 2010.

At the same time, the flood of money being pumped into the economy by policy makers, including $12.8 trillion in the U.S., will ward off deflation and cause longer-term yields to increase, traders say.

“Inflation threats are increasing the longer you pump cash into the system,” said David Keeble, head of fixed-income strategy in London at Calyon, the investment-banking unit of Credit Agricole SA. Subsequent steepening “will be more of a sell-off from the longer-end of the curve,” he said.

The U.S. Treasury yield curve has widened to 2.26 percentage points from 1.25 percentage points in December. It averaged less than zero in 2006 as traders correctly anticipated that the economy would enter a recession, causing inflation, which erodes the value of fixed-rate securities, to slow.

Steepest Curves

Curves in the U.K. and Italy are near the steepest levels in about 17 years, at 2.47 percentage points, respectively. Canada’s curve is 2.10 points, the most since 2002.

The shift accelerated as Japan, U.K. and U.S. central bankers cut short-term interest rates to near zero and embraced so-called quantitative easing policies by buying debt assets to keep rates down after exhausting other tools.

Merrill Lynch & Co. indexes show sovereign debt issued by the G-7 has lost 1.07 percent this year, including reinvested interest, amid a surge in government borrowing to finance the rise in spending needed to prop up contracting economies. That compares with a return of 14 percent in 2008 for Treasuries, the best annual performance since gaining 18 percent in 1995, the indexes show.

Deflation Concern

Government coupon securities issued by the G-7 and maturing in five years or less gained 0.52 percent this year, compared to losses of 0.74 percent for securities maturing in five years or more, according to Merrill. Among the 26 largest sovereign debt markets, the U.S., U.K. and Canada lost the most in April, Bloomberg data shows.

Deflation was the concern last year as U.S. bond yields fell to historic lows, the Reuters/Jefferies CRB Index of commodities tumbled 36 percent and U.S. home prices plunged 19 percent, according to the S&P/Case-Shiller index. The consumer price index fell to minus 0.4 percent in March from a year before, the first annualized decline since 1955, the Labor Department said April 15.

The Fed’s preferred measure of inflation, which tracks consumer spending and excludes food and fuel costs, rose at a 1.5 percent annual pace last quarter, the Commerce Department said April 29, approaching the lower end of central bankers’ longer-term forecasts.

‘Not Enough’

The difference between yields on Treasury Inflation Protected Securities, or TIPS, due in 10 years and notes that aren’t indexed to inflation was 1.41 percentage points. The so- called breakeven rate, which reflects traders’ outlook for consumer prices over the life of the debt, was negative 0.08 percent Nov. 20. Among the G-7, U.K. 10-year gilts have the highest breakeven rate at 2.20 percentage points.

President Barack Obama signed a $787 billion, two-year economic stimulus plan in February. Prime Minister Taro Aso of Japan unveiled a 25,400 yen ($255 billion) plan to stimulate growth. Germany, France and Italy have pledged a combined 107 billion euros ($142 billion) and the U.K. has promised 25 billion pounds ($37 billion).

Even with those measures, the global economy will contract 1.3 percent this year, according to the International Monetary Fund. While the Federal Reserve’s Open Market Committee said April 29 that the contraction has slowed and the outlook “improved modestly,” the economy may suffer as job losses and restricted credit inhibit consumer spending.

“The stimulus is not enough,” said Kevin Gaynor, head of economics and interest-rate strategy at Royal Bank of Scotland Group Plc in London. “It’s more about absorbing cyclical damage and bailing out the banking sector rather than starting a path toward economic growth.”

Lending Again

Banks curtailed lending to each other in August 2007, when losses from subprime mortgages left the world’s largest financial institutions with securities and financial contracts they couldn’t value. Markets froze in the wake of New York-based Lehman’s bankruptcy on Sept. 15, as traders speculated that if the 158-year-old firm could fail, so could any company.

Now, lending has resumed. The London interbank offered rate for three-month dollar loans fell to 1.01 percent on May 1, the lowest since June 2003.

The TED spread measuring the difference between Libor and Treasury bill rates, which rose as high as 4.64 percentage points on Oct. 10, narrowed to 0.86 percentage point last week. The Libor-OIS premium that indicates banks’ reluctance to lend to each other fell to 0.79 percentage point last week, the lowest level since before Lehman’s collapse, from 3.64 percent on Oct. 10.

Bond Sales

Companies have sold about $477 billion of bonds this year in the U.S., compared with $354 billion during the same period of 2008, according to data compiled by Bloomberg. The extra yield investors demand to buy U.S. corporate debt instead of Treasuries narrowed to 6.4 percentage points on May 1 from 8.96 percentage points on Dec. 15, according to Merrill Lynch’s U.S. Corporate & High Yield Master Index.

Rates on 30-year fixed mortgages averaged 1.76 percentage points more than 10-year Treasuries last week, down from 3.07 points on Dec. 19, the highest level since 1986, according to Bloomberg data.

“There will be a recovery and our view is we want to be ready to play that recovery,” said Michael Atkin, who helps oversee $12 billion in fixed-income assets as head of sovereign research at Putnam Investments in Boston.

Bank Benefits

Steeper yield curves are increasing trading revenue at banks. New York-based Goldman, the most profitable Wall Street firm before it posted its first quarterly loss since going public in 1999, reported net income of $1.81 billion for the first quarter on April 13. A week earlier, San Francisco-based Wells Fargo & Co. posted record earnings.

During the recession of 1991, the U.S. yield curve steepened to as much as 2.19 percent from 0.85 percent even as the economy contracted. Growth resumed in 1992, and the curve peaked at 2.68 percentage points in July of that year. It widened to 2.74 percentage points in 2003, 10 months before Institute for Supply Management’s manufacturing survey posted its highest reading since 1984.

Calyon’s Keeble said he will recommend investors move to shorter-maturity debt. An investor buying $100 million of two- year notes betting on a steeper curve will earn $1.2 million if the gap widens by 30 basis points, according to data compiled by Bloomberg. The figure is weighted so the value of a basis point move in either note has an equal dollar impact.

Yield curves “will probably get steeper,” said David Rolley, who helps oversee $106 billion as co-head of global fixed-income in Boston for Loomis Sayles & Co. “Investors will price in the recovery before” central banks raise rates.

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