The worst is over for the $10 trillion U.S. Treasury market following the biggest quarterly rout since 2010, say Wall Street’s largest bond trading firms.
After rising to as high as 2.4 percent last month from 1.88 percent at the end of 2011, the yield on the benchmark 10-year note will finish 2012 at 2.49 percent, according to the average estimate in a Bloomberg News survey of the 21 primary dealers that trade with the Federal Reserve. That’s the same as a January poll, suggesting the market isn’t ready to declare a bear market in bonds after a 30-year bull run.
Signs of strength in the economy, which caused a 5.56 percent loss in bonds maturing in 10 years or more last quarter, may fade in the second half of 2012, the dealers say. Tax cuts are expiring, $1 trillion of mandatory federal budget cuts are due to kick in and $100-a-barrel oil is eating into consumer spending. With inflation in check, Fed Chairman Ben S. Bernanke said last week that the central bank will consider further stimulus, even after upgrading its economic outlook March 13.
“The back-up that we’ve seen over the past three or four weeks was not fully justified by what we’re seeing in the data,” said Aneta Markowska, a senior U.S. economist at primary dealer Societe Generale SA in New York. The 10-year yield will end the year at 2.25 percent, she said in an interview March 27.
Dealer Holdings
Primary dealer holdings of U.S. government debt rose to $91 billion last month, from a net bet against the securities of $53.4 billion in May, according to the Fed. In the survey, 15 say the odds are that the Fed will need a third round of bond purchases, or quantitative easing, to bolster the economy.
The yield on the benchmark 10-year note dropped three basis points or 0.03 percentage point at 10:24 a.m. in New York, according to Bloomberg Bond Trader prices. The 2 percent security due in February 2022 rose 8/32, or $2.50 per $1,000 face amount, to 98 12/32.
Housing reports the last two weeks showed a key part of the economy remains under pressure. The Commerce Department said March 23 new home sales fell to a 313,000 annual pace in February, the slowest since October, from the 318,000 rate in January that was weaker than previously reported. The National Association of Realtors said existing-home sales eased to a 4.59 million rate last month from January’s 4.63 million.
‘Unusually Large Layoffs’
The economic recovery isn’t yet assured and unemployment remains too high, Bernanke told ABC News anchor Diane Sawyer, according to transcripts of the interview released March 27.
The remarks came a day after Bernanke said in a speech that the drop in the unemployment rate to 8.3 percent may reflect “a reversal of the unusually large layoffs that occurred during late 2008 and over 2009.” Significant further improvement would likely require faster growth, he said. The Fed hasn’t tightened monetary policy with joblessness at the existing level since it fought surging inflation in the 1980s.
“In the past week Bernanke’s gotten in front of every microphone he could find and gotten the market to realize that we shouldn’t have priced out QE3 and even if you don’t think it’s going to happen you have to attribute some sort of probability to it, and that he’s going to stay accommodative and potentially increase accommodation,” John Briggs, a U.S. government bond strategist at primary dealer RBS Securities Inc. in Stamford, Connecticut, said in an interview on March 28.
Forecast Range
Yield forecasts at the primary dealers range from 2 percent at RBS, Scotia Capital and Barclays Capital to 3 percent at Deutsche Bank AG, Jefferies & Co. and BMO Financial.
Even if the most bearish forecasts prove true, yields would remain below the average of 3.85 percent over the past decade, 4.98 percent over the past 20 years and 6.48 percent since 1982.
The bull market for bonds began after then-Fed Chairman Paul Volcker began to lower borrowing costs from a high of 20 percent in 1980 after taming inflation.
President Barack Obama needs the support of the bond market to help finance a budget deficit projected to exceed $1 trillion for the fourth year as he runs for re-election in November.
While the amount of marketable debt outstanding has more than doubled to $10.2 trillion from $4.34 trillion in mid-2007 as the U.S. sold bonds to pay for spending programs designed to pull the economy out of the worst financial crisis since the Great Depression, interest expense equaled 3 percent of the economy in fiscal 2011 ended Sept. 30. That’s down from 4 percent in 1999, when the U.S. ran budget surpluses.
Bond Losses
Bernanke helped spark last quarter’s selloff when the central bank upgraded its assessment of the economy at its March 13 policy meeting. Losses in long-term bonds were the most since they tumbled 8 percent in the fourth quarter of 2010, according to Bank of America Merrill Lynch indexes, and compare with a 3.22 percent return for company debt and a 12.6 percent gain in the Standard & Poor’s 500, including reinvested interest.
Traders immediately reduced bets the central bank would favor more bond purchases and moved forward the date that they anticipated the Fed would raise interest rates to 2013 from late 2014.
“At this point in the policy cycle it is common for market participants to get ahead of themselves,” said Vincent Reinhart, chief U.S. economist at primary dealer Morgan Stanley and a former senior Fed official, in an interview on March 28. “The market’s got a rosier view of the outlook.”
Reinhart forecasts 10-year yields will end the year at 2.25 percent, and there’s a better than even chance of QE3 after the Fed already bought $2.3 trillion of bonds from December 2008 to June to avert deflation and spur growth. It’s now replacing $400 billion of shorter-term maturity Treasuries in its holdings with longer-term debt in a policy traders call Operation Twist.
Rising Loans
There are enough signs of strength in the economy and credit markets to keep the Fed from adding more stimulus, according to Maury Harris, the chief economist at primary dealer UBS Securities LLC in New York. Fed data show commercial and industrial loans outstanding rose to $1.38 trillion as of March 14 from the post-crisis low of $1.2 trillion in October 2010.
“The banks are expanding lending now as a result of the earlier QE, and that’s a reason why now we’re seeing better job growth,” Harris said in a March 28 telephone interview. “You put so much in the system, some of it made a difference.”
UBS expects 10-year yields will end 2012 at 2.7 percent.
Gross domestic product in the U.S. will probably expand 2.2 percent in 2012, according to the median estimate of more than 70 economists surveyed by Bloomberg. That’s slower than the 3.1 percent posted in 2005 and 2.7 percent in 2006 before the recession and financial crisis.
‘Spring Slowdown’
“We’re going to have some Spring slowdown in housing, some Spring slowdown in employment, and the first opportunity they get to juice the system they will,” Steven Ricchiuto, chief economist in New York at primary dealer Mizuho Securities USA, said in a March 28 telephone interview in reference to Fed policy makers.
The firm sees 10-year yields ending the year at 2.5 percent, and places a greater than 50 percent chance on QE3.
RBC Capital Markets is focusing on Europe, where the sovereign debt crisis may still curb the global economy. European leaders capped new lending for bailouts last week at 500 billion euros ($667 billion), after a Germany-led coalition opposed a further expansion of the region’s anti-crisis firewall.
The International Monetary Fund’s mission chief to Greece, Poul Thomsen, said March 28 that while the nation has made an “aggressive” start, it will take at least a decade to fully complete the country’s restructuring. Two days later, Spain, under threat of falling victim to the crisis, said it will raise taxes and cut spending to achieve 27 billion euros in deficit cuts as it tries to trim its budget deficit by a third.
Tom Porcelli, chief U.S. economist at RBC Capital Markets, expects 10-year yields will end 2012 at 2.25 percent and the Fed will implement QE3, he said in a March 29 interview.
“Europe will continue to be a factor on the macro backdrop for the foreseeable future.”
Primary Dealer 10-Year Yield, Quantitative Easing Forecasts
Firm January March QE3?
Bank of America 2.4 2.4 Yes
Barclays 2.0 2 No
BMO Financial 2.4 3 Yes
BNP Paribas 3 2.7 Yes
Cantor Fitzgerald 2.5 2.63 Yes
Citigroup 2.45 2.45 Yes
Credit Suisse 2.25 2.5 Yes
Daiwa 2.4 2.6 No
Deutsche Bank 3 3 No
Goldman Sachs 2.5 2.5 Yes
HSBC 2.3 2.3 NA
Jefferies 3 3 Yes
JPMorgan Chase 2.5 2.5 No
Mizuho 2 2.5 Yes
Morgan Stanley 2 2.25 Yes
Nomura 2.48 2.75 Yes
RBC 2.25 2.25 Yes
RBS 2 2 Yes
Scotia Capital 3 2 Yes
Societe Generale 2.25 2.25 Yes
UBS 2.4 2.7 No
Mean 2.43 2.49
* ‘Yes’ on QE indicates odds of 50 percent or higher.
To contact the reporters on this story: Susanne Walker in New York at swalker33@bloomberg.net; Daniel Kruger in New York at dkruger1@bloomberg.net
To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net
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