-- The rally in 30-year Treasury bonds, the most profitable U.S. government securities in the past 15 months, may become a casualty of the Federal Reserve's efforts to ease a widening credit crunch.
Yields on so-called long bonds will increase because Fed Chairman Ben S. Bernanke may lower borrowing costs and cause consumer prices to rise at a faster pace, said Brian Carlin, head of fixed-income trading at JPMorgan Private Bank.
Investors will demand a ``higher risk premium,'' said Carlin, who helps oversee $100 billion of bonds in New York. ``Fed cuts may, in fact, turn out to be quasi-inflationary.''
Federal fund futures on the Chicago Board of Trade show traders are certain central bankers will cut the target rate for overnight loans between banks at their monetary policy meeting next month, after unexpectedly lowering borrowing costs for bank loans on Aug. 17.
While the Fed helped end a swoon in stocks and corporate debt, it increased concerns for investors in government bonds with the longest maturities. The move signaled that for the first time in more than a year, fighting inflation was no longer the central bank's top priority. The Fed, in a statement, said the risk posed to the economy by the collapse in the subprime mortgage market had risen ``appreciably.''
Carlin recommends buying two- and three-year Treasuries, and avoiding the long bond because its yield may climb as high as 5.25 percent by year-end, from 4.89 percent last week. If Carlin is right, the 30-year bond would lose 3.7 percent. Yields move inversely to bond prices.
Real Yields
The 5 percent Treasury maturing in May 2037 rose 1 28/32 last week, or $18.75 per $1,000 face amount, to 101 26/32 in New York, according to bond broker Cantor Fitzgerald LP. It fell 8/32 today, pushing the yield up to 4.90 percent.
Inflation erodes the value of fixed-income payments, so investors typically push yields higher when they expect consumer prices to rise. The 30-year bond yields about 3 percent after subtracting inflation. The real yield has averaged 2.65 percent since the Fed began saying in May 2006 that keeping prices in check was its main focus.
Thirty-year bonds have returned 10.8 percent since May 2006, including reinvested interest, while 10-year notes have gained 9.4 percent and two-year notes returned 7.2 percent, according to data compiled by New York-based Merrill Lynch & Co.
Treasuries gained as turmoil from losses on securities linked to mortgages to people with poor credit spread. Two hedge funds managed by New York-based Bear Stearns Cos. filed for bankruptcy, investors have refused to buy short-term debt backed by home loans and central banks injected more than $200 billion into the financial system to keep money markets from seizing up.
Yield Curve
The Fed is now ``dealing with this issue of potential financial market meltdown,'' said Derek Brown, a bond fund manager in Los Angeles at Transamerica Investment Management, which oversees $8 billion in fixed-income assets. ``They have to shift their focus from inflation fighting.''
The Fed's emphasis on containing inflation by increasing interest rates kept yields on longer-maturity Treasuries low relative to shorter-maturity debt.
Thirty-year bonds yielded 2.61 percentage points more than two-year notes on June 30, 2004, the day the central bank began raising its target rate from a four-decade low of 1 percent. By the time the rate reached 5.25 percent on June 29 last year, the gap, or yield curve, was 0.06 percentage point.
`About-Face'
Though they haven't raised rates since June 2006, policy makers have said after each subsequent meeting that faster inflation was a bigger risk than a slowdown in the economy. Investors took that to mean the Fed was ready to tighten credit to keep consumer prices under control.
The Fed reiterated that stance on Aug. 7. Just 10 days later it cut the discount rate, or the interest rate it charges banks, by 0.5 percentage point to 5.75 percent and made no mention of inflation. The gap between two- and 30-year yields has widened to 0.59 percentage point.
``We really saw an about-face from the Fed in the message they were telling the markets about fighting inflation,'' said Colin Lundgren, who manages $40 billion as head of institutional fixed income for RiverSource Institutional Advisors in Minneapolis. ``The message to the market was more favorable for long maturities a couple of weeks ago.''
Lundgren is increasing his fund's cash holdings.
`Comfort Zone'
The personal consumption expenditures index excluding food and energy, the measure of inflation policy makers use for inflation forecasts, rose 1.9 percent in June from a year earlier. Fed officials including Bernanke and Chicago Fed President Michael Moskow have said their ``comfort zone'' is from 1 percent to 2 percent.
One part of the bond market, inflation-protected Treasuries, is sanguine about inflation. The gap between 10-year Treasury yields and 10-year inflation-protected notes, which represents the inflation rate investors expect during the life of the securities, is 2.23 percentage points, down from 2.54 percentage points a year ago.
``Financial market volatility, in and of itself, doesn't require a change in the target federal funds rate,'' Federal Reserve Bank of Richmond President Jeffrey Lacker said Aug. 21. ``Policy needs to be guided by the outlook for real spending and inflation.''
When policy makers slashed their target to a four-decade low of 1 percent in June 2003 to spur inflation and ward off the risk of deflation, the 30-year bond had its worst month since at least 1981. The security fell 11 percent as its yield rose to 5.36 percent from 4.56 percent, Merrill Lynch data show.
Fed officials will probably vote to cut rates ``but not because they want to,'' said Jason Brady, a managing director at Thornburg Investment Management in Santa Fe, New Mexico, which oversees $4 billion in fixed-income.
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