(BN) Bernanke TIPS Trip Bears as Fed Fails to Spur Costs (Update1)

By Daniel Kruger
Aug. 11 (Bloomberg) -- For Federal Reserve Chairman Ben S.
Bernanke, there may never be a better time to stop buying U.S.
government debt.
With the Fed on pace to complete the planned purchase of $300 billion of Treasuries in September, the exit of this year’s biggest buyer is unlikely to raise yields by depressing prices, the world’s largest bondholders say. The market for Treasury Inflation Protected Securities shows traders expect inflation over the next 10 years to average 1.96 percent, which is 0.74 percentage points less than the past decade’s average and too little to erase the value of bonds’ fixed payments.
"At this stage it would probably be counterproductive for the Fed to extend this program," said Mihir Worah, who oversees the $14 billion Real Return Fund for Pacific Investment Management Co. in Newport Beach, California. "The market does not want it to be continued" because an expansion would renew concerns that money printed to fund it would fuel inflation, he said.
The Fed meets today and tomorrow, and policy makers probably will discuss the purchases and other quantitative- easing measures, which include buying $1.45 trillion in mortgage-related securities. The central bank has acquired $250 billion in U.S. debt since unveiling its plans on March 18, averaging $10.9 billion a week since mid-June. The acquisitions helped unfreeze credit markets by holding down yields on Treasuries, the benchmarks for lending throughout the economy.

Determination

Halting the program after consumers spent 0.4 percent less in June than a year ago will signal the Fed is determined to control inflation before it starts, analysts at Credit Suisse Securities USA LLC and RBS Securities Inc. said. Low inflation would make Treasuries’ coupon payments more desirable, keeping yields in check even longer.
"The Fed’s nonrenewal of QE should prove to be a positive," said Srini Ramaswamy, a JPMorgan Chase & Co. analyst in New York, in an Aug. 7 note.
The central bank hasn’t announced its plans for the program.
The Bank of England’s Aug. 6 decision to increase purchases of U.K. gilts by 40 percent to 175 billion pounds ($288 billion) surprised traders, pushing up prices on 10-year bonds. Their yields fell as much as 18 basis points to 3.64 percent, the biggest drop in almost three months, before rebounding.

Inflation Concerns

The Fed’s bond plans had fueled concern that they would cause inflation to accelerate. Andreas Hoefert, chief global economist at UBS Wealth Management in Zurich, predicted 5 percent long-term inflation in March. John Brynjolfsson, chief investment officer of Armored Wolf LLC in Aliso Viejo, California, issued a similar forecast in June. Ten-year yields hit 4 percent in June, up from the Dec. 18 figure of 2.04 percent, the lowest on record going back to 1953.
As the Fed purchases continued, yields retreated, closing yesterday at 3.78 percent. The median of 66 predictions in a Bloomberg survey sees rates on the benchmark 10-year falling to
3.69 percent by the end of the year. The consumer price index probably declined 1.9 percent in July from a year ago, the biggest drop since 1950, a Bloomberg survey’s median forecast shows. The Labor Department releases July’s CPI figure Aug. 14.
"They’re definitely on track" to end the quantitative easing program, said Carl Lantz, an interest-rate strategist in New York at Credit Suisse, one of 18 primary Treasury dealers that trade with the Fed. That "should calm some of the overblown inflation fears," he said.
Hoefert said he stands by his prediction that the purchases will cause inflation "because plain and simple it is wanted."
There likely will be a prolonged period of low inflation "which will be interpreted as a deflationary," he added in an e-mail.
"Inflationary pressures will occur on a longer horizon by 2011, 2012. Inflation expectations, though, might come earlier."

Small Expectations

The yield gap between 10-year TIPS and Treasuries, a measure of inflation expectations over the securities’ life known as the breakeven rate, is 1.96 percentage points. The market foresees inflation expectations of 2.53 percent on average from 2014 to 2019, according to another gauge, the five- year, five-year forward breakeven rate.
The expectations are so low that 10-year TIPS have become "fundamentally cheap," said Michael Pond, a strategist in New York at Barclays Capital Inc. He estimates the 10-year breakeven rate should be 2.25 points.
The central bank decided against expanding Treasury purchases in April and June as yields climbed. Fed Bank presidents Jeffrey Lacker of Richmond and Charles Evans of Chicago have said they oppose buying more. Only "a significant deterioration relative to our outlook" would justify more, Evans said in June.

‘Back Off’

Thomas Girard, who helps oversee $110 billion in fixed income for New York Life Investment Management, said his belief that the Fed will "back off" is part of the reason he bought 10-year Treasuries on Aug. 3 at a 3.72 percent yield.
When the Fed unveiled its strategy, deflation was the market’s dominant concern. Median Bloomberg survey predictions for CPI in 2009’s third quarter had fallen from 2.5 percent inflation in September to a 1.8 percent drop in consumer prices.
The U.S. economy was in its biggest quarterly contraction since 1980, and the Standard & Poor’s 500 Index had fallen to a 12- year low of 676.53. Yields on corporate bonds and Treasuries and the spreads between them were rising, choking off lending to consumers and companies.
"These credit easing programs, along with actions taken by the Treasury and other government entities, are crucial,"
Bernanke said March 20. They were aimed at "reducing interest rates on mortgage loans and other long-term credit to households and businesses," the Fed’s June 24 meeting minutes said.

‘Bearing Fruit’

Now, credit costs are returning to pre-crisis levels and recovery expectations are growing.
"The Fed and Bernanke in particular must be gratified that a lot of their actions are bearing fruit," said Wan-Chong Kung, who helps manage $89 billion at U.S. Bancorp’s FAF Advisors in Minneapolis.
Lawmakers and investors say Bernanke’s success in averting a depression probably will win him a second four-year term after his current one expires Jan. 31. By an almost three-to-one margin, investors say he has earned it, the first Quarterly Bloomberg Global Poll shows. Democratic Senator Jon Tester of Montana, a banking committee member, said another term is "pretty darn likely."
The median of 59 Bloomberg-survey forecasts sees the economy growing this quarter after four consecutive contractions.
The S&P 500 exceeded 1,000 on Aug. 3 for the first time since Nov. 4.

Mortgage Rates

Home buyers in the U.S. pay an average 5.49 percent on 30- year fixed-rate mortgages, according to Bankrate.com. That’s down from 6.4 percent in November 2008. The mortgages cost 1.70 percentage points more than yields on 10-year Treasuries, compared with 3.27 points in December, data compiled by Bloomberg show. The average gap for the five years ending with
2007 was 1.53 points.
The gap between corporate bonds and Treasury yields, which rose 80 basis points to 7.93 percentage points in the month before the Fed announced its purchase plan, has narrowed to 3.83 percentage points, Merrill Lynch & Co. indexes show. That’s lower than before Lehman Brothers Holdings Inc.’s Sept. 15 collapse froze credit markets. U.S. corporate bond sales this year have totaled $874.3 billion, 30 percent faster than last year’s pace, Bloomberg data show.

‘Supply Picture’

Spreads between Treasury yields and those for mortgages and agency debt also shrank, by more than half to about 35 basis points. The difference between what banks and the Treasury pay for three-month loans has fallen to 29 basis points, the lowest since March 2007, from a high of 4.64 percentage points during the crisis.
Even as the government sold a record $1.14 trillion in notes and bonds this year, the 10-year yield is below the 3.86 percent average since the credit market froze in August 2007.
The supply of new Treasuries is poised to slow, Goldman Sachs Group Inc. said July 28. The New York-based bank estimated that the U.S. will sell about $2.9 trillion of debt in the two years ending September 2010, 28 percent less than previously predicted.
"The supply picture’s getting a little better," said Stuart Spodek, co-head of U.S. bonds in New York at BlackRock Inc., which manages $474 billion in debt. Treasuries "represent decent value," he said.

Concern in Asia

Investors who had shunned longer-term Treasuries may become more willing to buy after the Fed steps aside, said William O’Donnell, the head of U.S. government bond strategy at RBS Securities Inc., a primary dealer in Stamford, Connecticut.
"Many people think that’s a road to hell in that it may ultimately fuel inflation," he said of the Fed’s asset purchases.
China has fretted about whether Treasuries are still safe but continued buying. "We are concerned about the security of our assets," Chinese Premier Wen Jiabao said on March 13. The country’s holdings have increased 10 percent this year to $801.5 billion and 58 percent over the past 12 months, the sharpest rise in six years.
In the U.S., investors bought 67 percent of the $656 billion in marketable debt sold by the Treasury through May, compared with 43 percent of $1.26 trillion issued in all of 2008, Treasury data show. This year’s purchases coincided with the personal savings rate climbing to May’s 14-year high of 6.2 percent.

Languishing Cash

The inflationary threat posed by the Fed buying Treasuries is a bigger risk to bond prices than its exit from the market, said James Camp, who helps invest $18 billion as managing director for fixed income at Eagle Asset Management in St.
Petersburg, Florida, a Raymond James unit.
If the Fed’s withdrawal depresses bond prices enough for the 10-year yield to hit 4 percent, investor demand will push it back down, he said. The benchmark fell as low as 3.58 percent the week after reaching 4 percent on June 11.
"I would be a buyer of Treasuries in the 4-to-4.25 percent range," Camp said.
Tony Crescenzi, a Pimco market strategist, said much of the money the Fed’s quantitative easing program created is languishing on bank balance sheets rather than being lent, diminishing its inflationary impact.
Fed data shows commercial and industrial loan volume is the lowest since February 2008. The U.S.’s supply of cash and cash equivalents rose 8.5 percent in the 12 months ended July, central bank statistics show. The speed, or velocity, at which that money changed hands, fell in the first quarter to the lowest since 1986, an indication that the new money isn’t producing inflation.
"There may be a lot of excess money in the system, but where is it going?" Crescenzi said. Banks are "mostly buying securities and sitting on cash. It’s hard to get worried from an inflation standpoint when there’s no velocity. Money’s not turning over."