China Can’t Buy Enough Bonds as Dollar No Deterrent

By Cordell Eddings and Lukanyo Mnyanda

Sept. 21 (Bloomberg) -- International investors are increasing purchases of Treasuries on a bet U.S. inflation will remain subdued, even as the dollar falls to the lowest levels of the year and the budget deficit tops $1 trillion.

Investors outside the U.S. bought 43.1 percent of the $1.41 trillion of notes and bonds sold by the Treasury Department this year, compared with 27.1 percent of the $527 billion issued at this point in 2008, government figures show. The Merrill Lynch & Co. Treasury Master Index of U.S. securities returned 1.18 percent in the third quarter after the worst first half on record as demand from the investor group that includes central banks climbed to record levels at Treasury auctions.

The trade-weighted U.S. Dollar Index’s 15 percent decline from its high this year on March 4 has proved no obstacle in Treasury auctions, aiding President Barack Obama’s efforts to sell an unprecedented amount of debt. Fund managers say their money is safe in the U.S. with expectations for inflation as measured by indexed bonds below the five-year average.

Treasuries are “starting to look like even a better value with a weaker dollar,” said Dave Chappell, who manages $90 billion in London at Threadneedle Asset Management Ltd., and has been buying longer maturity U.S. government debt.

The 10-year note yield rose 12 basis points last week, or 0.12 percentage point, to 3.46 percent, according to BGCantor Market Data. That’s the most since gaining 37 basis points in the five days ended Aug. 7. The 3.625 percent security due August 2019 fell 1, or $10 per $1,000 face amount, to 101 11/32.

Treasuries were unchanged today as of 10:01 a.m. in Hong Kong, with trading closed in Japan and Singapore for holidays.

Record Issuance

This week the U.S. will sell $112 billion of 2-, 5- and 7- year notes. The amount will be a record for that combination of maturities, exceeding the $109 billion sold the week of Aug. 24. Treasuries rallied that week, with the yield on the 10-year note falling 12 basis points to 3.45 percent.

Federal Reserve holdings of Treasuries on behalf of foreign accounts rose 16 percent to $2.07 trillion since the March high in the Dollar Index.

China, the biggest foreign owner of Treasuries, added $24.1 billion in July after net sales of $25.1 billion in June, raising its stake in U.S. government debt 3.1 percent to $800.5 billion, Treasury data showed on Sept. 16. The country’s holdings have risen 10 percent this year, after a 52 percent gain in 2008 amid the surge in demand for the safety of U.S. government debt as global credit markets froze.

Little Choice

Foreign governments have little choice than to buy Treasuries because they hold so many dollars. The U.S. dollar accounts for 65 percent for world currency reserves, up from 62.8 percent in mid-2008, according to the International Monetary Fund in Washington.

The Obama administration needs the foreign help to fund the debt sales needed for his $787 billion stimulus spending package. Chinese Premier Wen Jiabao said in March that the Asian nation was “worried” about the safety of its investment as a weakening dollar erodes the value of its record $2.1 trillion of foreign-exchange reserves.

“The interest rate on long-term Treasury bonds is at a very low level by historical standards,” said David Dollar, the U.S. Treasury Department’s economic and financial emissary to China on Sept. 11 at the World Economic Forum meeting in Dalian, China. “That says that the market has confidence the U.S. will get the fiscal problem under control.”

Inflation Protected Debt

Yields on U.S. inflation-protected debt show there’s little concern about consumer prices eroding the value of bonds’ fixed payments. The difference in rates on 10-year notes and Treasury Inflation Protected Securities, or TIPS, which reflects the outlook among traders for consumer prices, is 1.82 percentage points. While up from 0.04 points in November, the level is below the average of 2.19 points over the past five years.

The U.S. has the lowest so-called breakeven rates of any major sovereign debt market except Japan. The difference between three-year maturities is 0.71 point, below the average of 2.21 points this decade.

Prices of goods imported into the U.S. tumbled 15 percent in August from a year earlier, after a record 19.2 percent drop in July, the Labor Department said Sept. 11.

“There is no inflation on the horizon,” said Michael Cheah, who manages $2 billion in bonds at SunAmerica Asset Management in Jersey City, New Jersey. “The market is comfortable that the Fed will keep rates low and there isn’t much of an alternative.”

Current-Account Deficit

The Fed’s announcement June 24 that it anticipates the target rate for overnight loans between banks will stay at zero to 0.25 percent for an extended period is keeping two-year notes anchored near current levels. Policy makers meet Sept. 22-23 in Washington. Traders are pricing in less than a 50 percent chance of a rate increase before March, federal funds futures show.

A weaker dollar has increased concern among some investors as the budget and current-account deficits come back into focus in the currency market. The U.S. government and the Fed have spent, lent or committed more than $12 trillion in a bid to revive the economy and credit markets.

Economists forecast the current-account deficit will rise to 3.2 percent of gross domestic product in 2010 and 3.5 percent in 2011 from 2.9 percent this year as consumer and business spending boost imports and oil prices increase, according to the median estimates in Bloomberg News surveys.

‘Hard to Find’

“Even though U.S. asset markets are doing well, they’re not doing well enough,” Steven Englander, the chief currency strategist for the Americas at Barclays Capital Inc., said in an interview with Bloomberg Radio on Sept. 17. “The question is, what is there in the U.S. to attract capital? And that answer is hard to find.”

Investors buying a 10-year note today will lose 0.2 percent if yields rise to 3.57 percent by year-end as projected in a Bloomberg survey of forecasts. On an unhedged basis, European investors would have lost 13 percent on 10-year notes since the start of the year, according to Merrill Lynch index data.

Even with last week’s drop in bond prices, Treasuries have returned 2.8 percent in the past three months, including reinvested interest, beating the 2.3 percent return for mortgage-backed bonds, according to indexes compiled by Merrill. The rally reflects skepticism about the sustainability of the economic recovery once government stimulus ends.

Rising Unemployment

The Obama administration forecasts that unemployment in the world’s largest economy will rise above 10 percent in the first quarter. The jobless rate increased to 9.7 percent in August, a quarter-century high. Fed Chairman Ben S. Bernanke said in Washington Sept. 15 that the worst U.S. recession since the 1930s probably ended, while adding that growth may not be strong enough to quickly reduce unemployment.

“If you subscribe to the double dip school of thought this may not be a bad entry point for Treasuries,” said Steve Rodosky, the head of Treasury and derivatives trading at Newport Beach, California-based Pacific Investment Management Co., manager of the word’s biggest bond fund. “The longer-term risk is that the weaker dollar is the cause or affect of people diversifying their holdings or using other currencies as a global currency, but we are a long way from that.”

Yields on 10-year notes may fall toward 3 percent, the least in five months and down from 3.47 percent last week, as the inflation rate drops, Francesco Garzarelli, chief interest- rate strategist in London at Goldman Sachs Group Inc., wrote in a Sept. 15 research report.

“The international community has not lost favor with Treasuries, and the weakening currency allows an opportunity to increase their exposure,” Rodosky said.

Pimco’s Changes

Bill Gross, who runs Pimco’s Total Return Fund, increased holdings of government-related debt last month to the most in five years, according to the company’s Web site. Gross boosted the $177.5 billion fund’s investment in Treasuries, so-called agency debt and other bonds linked to the government to 44 percent of assets, the most since August 2004, from 25 percent in July.

The U.S. will sell $43 billion in two-year notes tomorrow, $40 billion of five-year debt on Sept. 23 and $29 billion in seven-year securities on Sept. 24.

Indirect bidders, the class of investors that includes foreign central banks, bought 49.4 percent of the notes at the two-year auction, up from 33 percent in July’s sale. They purchased 56.4 percent of the five-year notes, compared with 36.7 percent in July, and 61.2 percent of the seven-year securities, above the average of 43.7 percent at the prior six sales of that maturity.

“China and a few other central banks have grumbled about the dollar but they don’t have many other alternatives so they keep buying,” said Michael Atkin, head of sovereign research at Putnam Investments in Boston, who helps oversee $12 billion in fixed-income assets.

To contact the reporter on this story: Cordell Eddings in New York at Lukanyo Mnyanda in London at lmnyanda@bloomberg.net.