Treasuries Head for Biggest Gains Since 2011 on Low Inflation

By Daniel Kruger

Treasuries are on track for their best performance since 2011 as low inflation, higher yields relative to other sovereign borrowers and persistent global turmoil enhanced the allure of the securities.

U.S. debt pared 2014 gains for a second week as the Treasury sold $104 billion of notes and trading volume slowed before the Christmas holiday. Investors move forward their predictions of when the Federal Reserve will raise interest rates in 2015 amid signs of faster economic growth. Treasuries trading will have a recommended early close Dec. 31 and be shut the following day for the New Year’s holiday.
“Treasuries really present an awful lot of value, in light of the fact that the U.S. dollar is improving, which should also help restrain inflation,” said Christopher Sullivan, who oversees $2.3 billion as chief investment officer at United Nations Federal Credit Union in New York. “The trajectory of recent economic growth in the U.S. suggests the Fed can begin tightening monetary policy next year.”
The benchmark 10-year note yield has fallen 78 basis points this year, or 0.78 percentage point, to 2.25 percent in New York, according to Bloomberg Bond Trader prices. The 2.25 percent securities maturing in November 2024 finished the week at 99 31/32. The yield increased 17 basis points during the past two weeks.
The two-year yield, which is more sensitive to changes in central-bank policy, rose 36 basis points this year to 0.74 percent, on pace for its biggest increase since 2009.

Debt Returns

Treasuries have returned 5.6 percent this year, set for the best performance since 2011, according to the Bloomberg U.S. Treasury Bond Index. They lost 3.4 percent last year.
Economists had predicted the 10-year yield would jump to 3.44 percent as the Fed tapered its purchases of Treasuries and mortgage-backed securities this year, which it had been buying at a pace of $85 billion per month since the start of 2013.
Economists in a Bloomberg News survey conducted in January had forecast 2.8 percent growth in the U.S. gross domestic product for this year.
“We entered this year with great anticipation of an economic rebound that, by the end of April and the two months after that, everyone realized” wouldn’t be achieved, said Jim Vogel, head of interest-rate research at FTN Financial in Memphis, Tennessee.

Oil Shock

Diminished inflation pressures were highlighted by the plunge in oil prices as U.S. stepped up its extraction from shale while demand lessened as economic activity from Europe to China slowed and as the Organization of Petroleum Exporting Countries declined to cap production. The price of the global benchmark Brent crude has fallen 46 percent this year, the most since 2008.
Inflation expectations for the next five years have declined to 1.19 percent, down from 2.11 percent June 24, based on the difference in yields between Treasury Inflation-Protected Securities and U.S. government debt not tied to the consumer price index.
“Global inflation expectations were falling well before oil,” Vogel said. “Oil started as a supply story and then became a demand story and is closing out the year as a supply story.”
Treasuries also benefited from the widening gap for 10-year yields between the U.S. and Germany. The difference between the two securities widened to 1.66 percentage points from 1.10 percentage points at the end of last year. The gap at almost the record 1.69 percentage points reached in June 1999.

Crisis Demand

Demand was also bolstered by a various geopolitical crises including Russia’s annexation of Crimea region in February and the resulting standoff between it and Ukraine that led to sanctions by the U.S. and European nations against Russia.
A report this week showed the U.S. economy expanded an annualized 5 percent in the third quarter, exceeding the highest forecast among 75 economists surveyed by Bloomberg.
Fed Chair Janet Yellen signaled Dec. 17 that the central bank is on track to raise interest rates next year as the economy improves. The benchmark rate has been in a range of zero to 0.25 percent since 2008.
The government sold $104 billion of securities this week, ending with an auction of $29 billion of seven-year notes on Dec. 24, before the market closed for the Christmas holiday.

Auction Attendance

Investors submitted $6.59 trillion of bids for $2.21 trillion of Treasury notes and bonds this year, or 2.98 times the amount of tenders per dollar of debt sold. That is up from last year’s 2.87 bid-to-cover ratio, as the measure is known, and the fourth-highest on record after 2010, 2011 and 2012, when the record of 3.15 times was set.

Fed funds futures show a 67 percent probability that the central bank will raise rates by September, up from a 45 percent likelihood at the end of last month. Forecasters in Bloomberg News surveys are calling for the 10-year yield to rise to 3.01 percent by the end of 2015, while the 30-year bond is predicted to reach 3.70 percent.

“It appears investors are positioning for higher rates again,” said Tyler Tucci, a U.S. government-bond strategist at Royal Bank of Scotland Group Plc’s RBS Securities unit in Stamford, Connecticut, one of 22 primary dealers that trade with the Fed. “As long as things don’t get any worse and inflation doesn’t get worse” policy makers “are OK with getting off the zero bound sometime mid-next year.”

To contact the reporter on this story: Daniel Kruger in New York at [email protected]