Bond investors back Fed forecast to avoid recession

Written by Bloomberg | Updated: Aug 30 2011, 06:17am hrs
Bond investors are backing Federal Reserve chairman Ben S Bernankes forecast that the US will avoid another recession.

The economy has never contracted with the difference between 10- and 30-year Treasury yields as wide as the current 1.33 percentage points, or 133 basis points, since the so-called long bond was first issued in 1977. The gap, which is more than double the 49 basis-point average of the past 20 years, has ranged from negative 56 to positive 41.9 at the start of the last five recessions, beginning in January 1980.

While reports this month showed manufacturing dropped to a two-year low and the worst consumer confidence since November 2008, investors say the Feds pledge to keep interest rates near zero until mid-2013 will underpin growth. The commerce department may say on Monday that personal spending, which accounts for about 70% of the economy, rose 0.5% in July, above the 0.3% average since 2000, according to the median of more than 60 estimates in a Bloomberg News survey.

There is a lot of fear, but US growth is not dead, Andrew Richman, who oversees $10 billion as a strategist in Palm Beach, Florida, for SunTrust Banks private wealth management division, said in an interview.

The yield curve, as the gap between short- and long-term rates is known, shows the market expects the economy will be strong enough to keep inflation from slowing, and eventually Treasury yields will have to rise, he said.

A commerce department report on August 26 showed that gross domestic product grew at a 1% annual rate last second quarter, compared with an initial estimate of 1.3%. The data also showed corporate profits jumped and wages and salaries were revised up at the start of 2011 for the biggest gain in more than four years.

Although important problems certainly exist, the growth fundamentals of the United States do not appear to have been permanently altered by the shocks of the past four years, Bernanke said after the report at a symposium in Jackson Hole, Wyoming, hosted by the Federal Reserve Bank of Kansas City. It may take some time, but we can reasonably expect to see a return to growth rates and employment levels consistent with those underlying fundamentals.

Yields on 10-year notes rose last week for the first time since the period ended July 22, climbing 13 basis points to 2.19% in New York, according to Bloomberg Bond Trader prices. The benchmark 2.125% security due in August 2021 fell 1 4/32, or $11.25 per $1,000 face amount, to 99 13/32. Thirty-year bond yields jumped 14 basis points to 3.54 percent.

Ten-year rates were 2.21% and long bonds yielded 3.54% on Monday as of 9:26 a.m. in London.

The relationship between short- and long-term yields is a closely watched indicator. Three-month bill rates have topped 10-year note yields eight times since 1960, with recessions following in six of those cases. There hasnt been a contraction that wasnt preceded by an inverted curve in that period.

Typically, longer-term yields exceed short-term ones because investors demand a higher premium to compensate for the risk that a growing economy sparks inflation over time.

Because the Fed has pegged rates on short-dated debt near zero since 2008 and spent $600 billion buying Treasuries due mainly in less than 10 years between November and the end of June through its quantitative easing, investors are now looking at the difference in yields between long maturity bonds, according to Carl Riccadonna, a senior economist at Deutsche Bank Securities Inc. in New York.

The US is sick, but not dying, Riccadonna said in a phone interview on August 24. The firms parent, Deutsche Bank AG, is one of the 20 primary dealers of US government securities that trade with the Fed. The steep curve is a vote of confidence from the market that, while the near-term outlook isnt great, the market doesnt think we are slipping into recession, and growth and inflation will pick up.

Ten-year notes had higher yields than 30-year bonds in January 2000 before the 2001 recession, and again in January 2006, Bloomberg data show. Growth contracted as much as 8.7%at the worst of the recession that began in December 2007 and ended in June 2009. The difference this year has averaged 118 basis points, the widest ever, and the most since 98 basis points in 2002, according to the data. It has averaged 52.8 since the start of 2000. While yields rose last week, they are still at about record lows, signaling that investors dont expect strong growth.