The worst two months for the U.S. Treasury market since 2004 failed to turn two of Wall Street's biggest bulls into bears, and history suggests they may be right.
While Barclays Plc says faster inflation means more “carnage'' is in store for the fixed-income market after U.S. debt lost 2.89 percent in April and May, Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc. predict a rally in two- year Treasury notes.
Goldman, the most profitable securities dealer, and Lehman, the top-ranked bond research firm in Institutional Investor's annual survey for eight years, bet the economy is too weak to spark runaway inflation and an increase in the Federal Reserve's target interest-rate for overnight loans between banks. Though futures traded on the Chicago Board of Trade show a 62 percent chance policy makers will boost the fed funds rate by year-end, they haven't started to raise borrowing costs with growth below an annualized 2 percent rate since 1980.
“The capital markets are underestimating how sluggish the economy is going to be,'' said Thomas Girard, a managing director at New York-based New York Life Investment Management, which oversees $110 billion in fixed income assets. “Any tightening priced into the fed funds futures market is premature at this stage of the game.''
Two-year Treasuries, more sensitive than longer-maturity debt to changes in expectations for monetary policy, rose last week by the most since the period ended Feb. 29, pushing yields down 27 basis points to 2.38 percent, according to BGCantor Market Data. The price of the benchmark 2.625 percent security due in May 2010 gained 1/2, or $5 per $1,000 face amount, to 100 15/32. The price was unchanged today.
Bernanke's `Concern'
Goldman forecasts that two-year yields will fall to 1.9 percent by year-end, while Lehman expects 1.8 percent. The median estimate of 49 economists and strategists surveyed by Bloomberg is for 2.24 percent. In September 2001, when the fed funds rate was 3 percent both firms correctly foresaw that it would decline to at least 2 percent. The median forecast was 2.5 percent.
Growing speculation that the Fed may boost rates this year drove the yield to 0.69 percentage point more than the fed funds rate on May 29, the most since May 2005. In January it was 1.90 percentage points below the rate, currently 2 percent. A basis point is 0.01 percentage point.
Fed Chairman Ben S. Bernanke said in an address June 4 at Harvard University in Cambridge, Massachusetts, that data showing the public expects price increases to accelerate is a “significant concern'' for the central bank.
Weaker Case
The case for an increase became weaker on June 6, as the Labor Department said that the unemployment rate surged to 5.5 percent in May from 5 percent in April. The gain was the biggest since February 1986.
“The economy is not performing at a rate that even remotely suggests they should raise interest rates along the lines that the markets are implying,'' said Edward McKelvey, a senior U.S easy payday loans. economist at Goldman in New York.
In the first three months of the year the economy grew at a 0.9 percent annual pace, the Commerce Department said May 29. The median estimate for 2008 is 1.30 percent, according to a survey of 78 economists by Bloomberg News. For 2009, it's 2 percent.
While growth is slow now, faster inflation may force investors to demand higher yields, according to Barclays. The inflation rate has almost doubled since August, with consumer prices rising by 4.1 percent on average since November. Barclays expects two-year yields will rise to 3.2 percent by year-end.
Barclays Says `Sell'
“U.S. bond markets are a sell,'' Tim Bond, head of global asset allocation at Barclays in London, wrote in a report on May 23. “The combination of easing credit-market pressures, better U.S. growth and soaring inflation is likely to cause carnage in the fixed-income markets this summer.''
Brian Wesbury, the chief economist at the Joint Economic Committee of Congress from 1995 to 1996 who is now at First Trust Advisors LP in Lisle, Illinois, concurs. He predicts a rise in yields to 3.45 percent. Though not as bearish, Morgan Keegan Inc. in Memphis, Tennessee, and the National Association of Home Builders in Washington both forecast an increase to 2.9 percent.
Even after last week's jobs report, futures on the Chicago Board of Trade show the odds of a rate increase are 62 percent.
Lehman Counters
Lehman counters that the futures market turned out to be more than a year early when pricing in rate increases as the recessions of 1990-1991 and 2001 ended.
The Fed's target was 6 percent at the end of March 1991, when the National Bureau of Economic Research says the recession that began in July 1990 ended. Policy makers kept slashing borrowing costs until September 1992, when the rate fell to 3 percent. When the 2001 recession ended in November, the rate was 2 percent; the Fed didn't stop lowering its target for the fed funds rate until it reached 1 percent in June 2003.
Futures “are trying to anticipate an old-fashioned business cycle recovery when the economy would come roaring back and the Fed would be hiking almost immediately,'' said Ethan Harris, Lehman's chief U.S. economist. “The last two business cycles have had very muted recoveries. They didn't match previous history. This business cycle is going to be the same.''
Harris expects the Fed to lower its target fed funds rate to 1.75 percent by year-end.
While Bernanke indicated the Fed isn't likely to lower borrowing costs, he also said that “we see little indication today of the beginnings of a 1970s-style wage-price spiral.''
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