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Monday, November 16, 2009

toward a “new normal” of lower long-term growth and higher unemployment than over the previous decade- Edmund Phelps

If you understand,(fully) everything noted here, you're better informed than me

Geithner Bond Wise Men Bury Warning as Options Rise (Update2)

By Liz Capo McCormick

Nov. 16 (Bloomberg) -- The options market shows investors are growing increasingly wary that U.S. debt sales may push yields higher even as inflation remains in check.
The cost to hedge against rising yields on Treasuries as measured by the so-called skew in options on interest-rate swaps is at a record high, according to Barclays Plc data. At more than 37 basis points, the measure is almost 40 times higher than the average before credit markets seized up in August 2007.
The 13-member committee of bond dealers and investors that Treasury Secretary Timothy Geithner depends on for advice, and includes officials of Pacific Investment Management Co. and Goldman Sachs Group Inc., highlighted the surge on page 36 of a 67-page report on Nov. 3. On the same page, they showed inflation expectations are subdued based on gauges watched by the Federal Reserve. In their discussions, the group noted that a second year of government debt sales approaching $2 trillion may weigh on investors as the Fed stops buying notes and bonds.
“The forward inflation rates show that inflation is off the agenda for the foreseeable future, with some still seeing a risk of deflation,” said Moorad Choudhry, head of Treasury in London at Europe Arab Bank Plc and author of more than a dozen books on finance and markets. “However, at the same time everyone is buying protection against higher yields.”
Rising yields on Treasuries, which are used as a benchmark for everything from mortgage rates to corporate bonds, may hamper Chairman Ben S. Bernanke’s efforts to reduce borrowing costs for businesses and consumers as the economy struggles to recover from the deepest recession since the 1930s and rising unemployment curbs consumer spending.

Jobless Recovery
Federal Bank of San Francisco President Janet Yellen raised the prospect of a “jobless recovery” in a Nov. 10 speech in Phoenix, while Dennis Lockhart, who heads the Atlanta Fed, predicted a “relatively subdued pace of growth” this quarter and beyond. Unemployment climbed to a 26-year high of 10.2 percent last month.
The economic recovery will probably “run out of gas” as it heads toward a “new normal” of lower long-term growth and higher unemployment than over the previous decade, Nobel laureate Edmund Phelps said in an interview with Bloomberg Television on Nov. 6.
The yield on the benchmark 3.375 percent security maturing in November 2019 fell three basis points to 3.39 percent at 7:36 a.m. in New York, according to BGCantor Market Data.

Option Volatility
Ten-year yields have risen from a low this year of 2.14 percent on Jan. 15 as bond prices fell, generating a loss for investors of 7.4 percent after reinvested interest, according to Bank of America Corp.’s Merrill Lynch U.S. Treasury, Current 10- Year Index. Yields will reach 3.8 percent by the end of June and 4.16 percent at the end of 2010, according to Bloomberg surveys that put a greater weighing on recent forecasts.
The option volatility skew soared to a record 37.65 basis points, or 0.3765 percentage point, on Oct. 30 from negative 13.65 basis points a year earlier. The skew measures the difference between volatility, which is a gauge of prices and demand, on one-year options that allow investors to lock-in paying fixed rates on 10-year interest-rate swaps and those that grant the right to receive fixed rates. The difference typically widens when traders anticipate a rise in yields.
“The supply/demand skew is totally imbalanced as more people want to buy the protection against higher rates and very few are willing to supply it,” said Piyush Goyal, a fixed- income strategist in New York at Barclays. The firm is one of the 18 primary dealers in U.S. government securities required to bid at Treasury auctions.

Forward Inflation
Next to the option volatility skew graph, the Treasury Borrowing Advisory Committee, known as TBAC, included a chart of the so-called five-year five-year forward breakeven inflation rate. This rate, derived from yields on Treasury Inflation Protected Securities and nominal Treasuries, was 3.20 percent last week, compared with the average this decade of 2.65 percent, according to Fed data.
The presentation and minutes from Treasury meeting with the TBAC were released on Nov. 4, the same day the Fed said at the completion of a policy meeting that it would keep rates near zero for “an extended period” as long as inflation expectations are stable and unemployment fails to decline.
Outside of rising yields, there is little evidence that demand for Treasuries waned as the amount outstanding rose to $7 trillion in September from $4.34 trillion before credit markets seized up in August 2007.

Borrowing Costs
Interest paid by the U.S. dropped by $67.8 billion in fiscal 2009 ended Sept. 30, government data show. Yields on 10- year Treasuries are less than half the average of 7.31 percent over the past 40 years. On average, investors bid for 2.58 times the amount of securities sold at each of the 68 Treasury auctions this year, compared with 2.18 times at the 44 auctions at this point in 2008, according to Bloomberg calculations.
Indirect bidders, the class of investors that includes foreign central banks, have taken 45 percent, or $805.7 billion, of the $1.799 trillion of notes and bonds sold by the Treasury through Nov. 10, compared with 28 percent, or $213.2 billion, of the $750 billion this time last year.
“As long as we continue our regular and predictable approach to financing the U.S. government, we will continue to attract domestic and international capital,” said Matthew Rutherford, Deputy Assistant Secretary for Federal Financing. “We expect that demand for our securities will remain extremely strong.”

Displacing Investors
Bank holdings of government securities and debt of mortgage companies Fannie Mae in Washington and McLean, Virginia-based Freddie Mac increased to $1.39 trillion in the week ended Oct. 21 from $1.26 trillion a year earlier.
What’s different now is that the Fed is no longer buying Treasuries as part of a so-called quantitative easing plan. The central bank finished a seven-month program in October to acquire $300 billion in Treasuries. It will complete the purchase of $1.25 trillion in agency mortgage-backed securities and about $175 billion of agency debt by April.
Buying agency debt is good for Treasuries because it displaces investors in that market, forcing them into Treasuries. Barclays strategists estimated in a Nov. 12 report that this accounted for another $750 billion of Treasury purchases.

‘Pressure Rates’
“Federal Reserve purchases of securities has artificially reduced supply of fixed-income securities coming into the market,” the minutes from the Nov. 3 TBAC meeting with the Treasury said. “Next year, financial markets should expect even greater issuance with no support. Such an outcome could pressure rates,” according to the minutes, which don’t list individual speakers.
The TBAC was formed shortly after World War II and made official through a 1972 act of Congress. It offers quarterly recommendations to the Treasury Secretary on managing the government’s debt. Members are appointed by the group’s chairman, currently Matthew Zames, the co-head of fixed income at New York-based JPMorgan Chase & Co.
The group includes Paul McCulley, a managing director at Newport beach, California-based Pimco, the world’s biggest manager of bond funds; Scott Amero, chief investment officer of New York-based BlackRock Inc., which manages more than $500 billion; and Ashok Varadhan of Goldman Sachs in New York.

‘Depth and Breadth’
“You have to be impressed with the depth and breadth of experience on this committee,” said David Ader, the head of government bond strategy at Stamford, Connecticut-based CRT Capital Group LLC.
The group is similar to the “Five Wise Men” of Germany, a government-appointed panel of economic advisers that has counseled the government on matters related to the economy and the nation’s finances for almost half a century. That group now includes one woman. Dana Emery, executive vice president at Dodge & Cox Inc., and Irene Tse, managing director at Duquesne Capital Management LLC, serve on the TBAC.

Treasury debt-management director Karthik Ramanathan said Nov. 3 that bond market participants should expect another year of government sales of as much as $2 trillion with the U.S. headed for a second straight year of budget deficits exceeding $1 trillion. The U.S. issued $1.9 trillion of so-called coupon securities during the fiscal year that ended in September.
Potentially putting more pressure on longer-term government securities is Treasury’s plan to increase the average maturity of Treasury debt to a range of between six and seven years, up from 4.42 years currently. The Treasury aims to lengthen maturities over the next three to five years.

‘Retain Our Flexibility’
That means more sales of longer-term debt. Thirty-year bonds fell Nov. 12 after the government auctioned $16 billion of the securities, a record for that maturity.
“Our current suite of issuance should allow the average maturity of the debt to gradually rise back to historic levels,” Rutherford said. “It is important to remember that this is simply a projection. We must retain our flexibility, given the uncertainty surrounding our financing needs.”
The new bonds drew a yield of 4.469 percent, higher than the average forecast of 4.424 percent in a Bloomberg News survey of five primary dealers and a sign of weak demand. The bid-to- cover ratio was 2.26, the least since May and below the average of 2.39 at the last 10 auctions.
“We are at a critical point as far as supply goes as we are now without the biggest buyer, which was the Fed,” said Jim Bianco, president of Chicago-based Bianco Research LLC. “The supply issue isn’t so much that it will raise rates across the board. The trick is going to be how much debt the Treasury can issue further out the yield curve without shooting up rates now that the Fed isn’t buying.”
To contact the reporter on this story: Liz Capo McCormick in New York at Emccormick7@bloomberg.net. Last Updated: November 16, 2009 07:48 EST

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