Is the market buying what the Fed is selling?

October 30, 2014 08:48 AM

The difference between yields on U.S. two-and 30-year debt narrowed to lowest level since November 2012 on speculation the Federal Reserve will raise interest rates next year while inflation remains restrained.

Treasuries rallied as investors sought to mirror month-end changes in benchmark indexes and on lower-than-projected consumption spending, tempering a report that showed the U.S. economy grew more than forecast in the third quarter. Even with the drop in yields, demand from international investors increased as German equivalent yields tumbled. The U.S. auctioned $29 billion of seven-year notes.

“The Fed is moving incrementally closer to tightening, but the long-term securities are outperforming both on the view inflation is not going to be a risk anytime soon, and relative value against our global counterparts,” said Thomas Simons, a government-debt economist in New York at Jefferies Group LLC, one of 22 primary dealers that trade with the Fed. “It’s funny to think of Treasuries as relatively high-yielding, but they are when you look at high-grade European debt.”

The gap between two-year and 30-year yields, known as the yield curve, fell to 255 basis points, or 2.55 percentage points, as of 1:02 p.m. in New York, according to Bloomberg Bond Trader prices. It touched 252 basis points, the lowest level on a closing basis since November 2012.

The two-year note yield dropped one basis point to 0.48%, while the 30-year bond yield fell two basis points to 3.03%.

Long Bonds

U.S. Thirty-year bonds, the longest maturity and those most sensitive to the outlook for inflation, are outperforming. They returned 3.4% this month through yesterday, while two-year notes were little changed, according to Bank of America Merrill Lynch indexes.

“Inflation is benign and is not a threat at this point,” said Sean Simko, who oversees $8 billion at SEI Investments Co., in Oaks, Pennsylvania. “The personal consumption data is a bit softer. The Fed conveyed they feel the lack of pressure is transitory. I’m not sure the market’s buying it.”

Inflation trailed the Fed’s 2% target as core personal consumption expenditures rose 1.4%, unchanged from the previous quarter.

The difference between U.S. 10-year yields and its German equivalent reached 1.45 percentage points, the highest level since Oct. 6.

German Outlook

German inflation, calculated using a harmonized European Union method, rose an annualized 0.7% in October, down from 0.8% last month, the Federal Statistics Office in Wiesbaden said. A Bloomberg News survey called for an increase to 0.9%.

Treasuries were also supported by buying for month-end extensions of duration, which calculates how much prices change when yields rise or fall.

Fixed-income funds that manage portfolios against benchmark indexes, including Barclays Plc’s U.S. Aggregate Index, typically buy longer-term Treasuries as a month ends to align the interest-rate sensitivity of their holdings with the indexes. The Barclays gauge will extend its duration by 0.07 year Nov. 1, compared with 0.09 year for Oct. 1.

“They were waiting for the Fed to be out of the way and the risk is they will have to do a bit of buying,” said David Ader, head of U.S. government-bond strategy at CRT Capital Group LLC in Stamford, Connecticut.

Fed Outlook

A majority of Fed policy makers at their meeting yesterday set aside concern that the inflation rate is low, voting to proceed with plans to end their third round of asset purchases.

The Federal Open Market Committee cited “solid job gains and a lower unemployment rate” since its previous gathering in September. It also maintained a commitment to keep interest rates low for a “considerable time,” especially if projected inflation continues to run below its 2% goal.

Policy makers have kept their benchmark, the target for overnight lending between banks, in a range of zero to 0.25% since December 2008.

Today’s seven-year sale was the last of four note auctions this week.

The $35 billion five-year auction yield yesterday was 1.567%. The Treasury also sold $15 billion of two-year floating-rate notes at a high discount margin of 0.053%, compared to 0.041% last month. The U.S. auctioned $29 billion of two-year debt on Oct. 28 at a yield of 0.425%.

The yield difference between 10-year notes (CBOT:ZNZ14) and similar-maturity Treasury Inflation Protected Securities, a gauge of expectations for consumer prices over the life of the debt, was 1.90 percentage points. The figure has fallen from this year’s high of 2.31 set in January.

The U.S. economy capped its strongest six months in more than a decade, as gains in government spending and a shrinking trade deficit made up for a slowdown in household purchases.

GDP grew at a 3.5% annualized rate in the three months ended September after a 4.6% gain in the second quarter, Commerce Department figures showed. It marked the strongest back-to-back readings since the last six months of 2003. The median forecast of 87 economists surveyed by Bloomberg called for a 3% advance.

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