The Federal Reserve may keep interest rates at record lows for the longest period since World War II as the economic slowdown that sparked a four-month bond rally worsens, according to Treasury market signals.
The 3 percentage point gap between yields for three-month and 10-year Treasuries indicates the economy may grow 1.1 percent in the 12 months ending June 2012, a study by the Fed Bank of Cleveland says. That’s less than half the central bank’s current forecast, and may delay any rate increase from the zero- to-25 basis point range held since December 2008.
Slower expansion means the Fed is unlikely to tighten credit until June 2012, the longest static period since the government forced the central bank to buy Treasuries during the 1940s. Any spending cuts agreed by President Barack Obama and Congress before the Aug. 2 deadline to raise the $14.3 trillion debt limit may restrain the economy.
“No one is looking for very spectacular growth,” said Krishna Memani, director of fixed income at OppenheimerFunds Inc. in New York, who helps manage $70 billion. The chance of the Fed lifting borrowing costs “is significantly lower today than it was six months ago,” Memani said. “Growth expectations in the U.S. and global growth expectations are probably lower and more realistic.”
Confidence in the economy has waned since February, when 10-year Treasury yields reached a high for the year of 3.77 percent, and federal fund futures showed a 51 percent chance of a central bank rate increase by December. That percentage dipped to 39 percent in April and stands at 10 percent.
The yield on the benchmark 10-year note fell to 3.03 percent on July 8, a drop of 16 basis points, or 0.16 percentage point, for the week. The 3.125 percent note due May 2021 rose 1 10/32, or $14.06 per $1,000 face amount to 100 26/32, Bloomberg Bond Trader prices show. Three-month bill rates are 0.02 percent.
Treasuries were little changed today as of 11:54 a.m. in Tokyo.
Bank of America Merrill Lynch bond indexes show Treasuries have returned 4.7 percent since yields peaked Feb. 8, beating the 2.3 percent gain for the Standard & Poor’s 500 stock index.
The economy’s inability to produce jobs may be the biggest obstacle for the Fed before it can remove the support it has provided with purchases of $2.3 trillion in assets and the reduction of its overnight lending rate to near zero.
The U.S. has added 1.7 million jobs since the start of 2010, after losing 8.7 million in 2008 and 2009. The unemployment rate was 9.2 percent in June, up from 8.8 percent in March and 4.4 percent in 2007.
Fed Chairman Ben S. Bernanke said June 7 that policy makers “cannot consider” the recovery to be established until they see a “sustained period” of strong job creation. The Fed said it sees expansion of between 2.7 percent and 2.9 percent.
“Bernanke’s going to be comfortable at zero for quite a while, and downright concerned about the direction and momentum,” said John Fath, a principal at the investment firm BTG Pactual in New York who helps manage $2.5 billion. “The momentum was turning up from December through March. It’s clearly gone the other way.”
Policy makers will wait until mid-2012 to raise rates for the first time in six years, according to average forecast of 58 economists in a Bloomberg News survey published July 8.
The last time the Fed maintained such prolonged monetary support for the economy was from 1937 to 1947 when it kept its “rediscount rate,” or the discount it applied to commercial banks borrowing cash against high quality promissory notes they had issued, at 1 percent.
From 1941 to 1951 the central bank also bought Treasuries as America grappled with the need to fund World War II, convert the U.S. back to a peacetime economy, and pay for the Marshall Plan to rebuild Western Europe.
“We are fighting a war,” said David Jones, 73, former vice chairman of Aubrey G. Lanston & Co., one of the original primary dealers established by the Fed in 1960. “This time it’s economic.”
U.S. employers added 18,000 workers in June, the fewest in nine months, and the unemployment rate rose to 9.2 percent, the highest level this year, the Labor Department said July 8. The median estimate in a Bloomberg News of survey 85 economists called for a gain of 105,000.
Economists use the yield curve to gauge the forecast the economy’s direction. Three-month bill rates have topped 10-year note yields eight times since 1960, with recessions following in six of those cases. There hasn’t been a recession that wasn’t preceded by an inverted curve in that period.
Rates on three-month bills rose past 10-year note yields in July 2006 after the Fed boosted its target rate for overnight loans between banks to 5.25 percent. The curve remained inverted through May 2007, just months before the economy began contracting, according to the National Bureau of Economic Research. The recession ended in June 2009.
“Few, if any” predictive measures are consistently better at forecasting the economy’s direction, Joseph G. Haubrich, head of banking and financial institutions research at the Cleveland Fed, said in an e-mail response to questions last week.
Fed policy has made it “sort of pointless” to use the curve to forecast growth because short-term yields are anchored by a target rate near zero, said Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch in New York, a primary dealer. Misra said she now focuses on the difference between five- and 30-year yields, which are less influenced by the Fed.
That part of the curve has widened to 2.7 percentage points from 2.23 percentage points March 31, with shorter-term yields falling as traders increase bets on “how long the Fed will be forced to be accommodative” and 30-year yields rising on the “fiscal risk” that debt ceiling talks fail, Misra said.
“Although our approach is somewhat pessimistic as regards the level of growth over the next year, it is quite optimistic about the recovery continuing,” Haubrich and Timothy Bianco, a researcher at the Cleveland Fed, wrote in a June 30 report.
Even though the economy is struggling to add jobs, earnings growth in the S&P 500 is climbing back to the average rate since the 1960s. Net income may rise 19 percent in 2011, according to analyst estimates compiled by Bloomberg.
The Fed completed its $600 billion of purchases of Treasury debt on June 30, though it could continue to reinvest about $300 billion of proceeds from maturing mortgage-related assets and government securities into U.S. government debt in order not to contract the supply of money.
“Inflation risk is probably further away than we think and strong growth is probably further away as well,” Eric Pellicciaro, head of global rates investments at BlackRock Inc. in New York, which manages $1.14 trillion in fixed income, said in a Bloomberg Television interview. “We ultimately think this short-term rise in yields is more of an opportunity.”
Yields on 10-year Treasuries are likely to remain within a range between 2.75 percent and 3.5 percent, Pellicciaro said.
House Speaker John Boehner said on July 9 he will pursue a smaller deficit reduction accord than the as much as $4 trillion one that President Barack Obama is seeking because the White House won’t approve a bigger deal without tax increases.
“I believe the best approach may be to focus on producing a smaller measure,” Boehner said in a statement before a meeting the president was scheduled to hold with congressional leaders.
Treasury 10-year yields near 3 percent reflect expectations that lawmakers will reach an agreement on raising the debt ceiling that will include significant spending cuts, and that those cuts will impede growth in the short-run, said Ajay Rajadhyaksha, co-head of fixed-income strategy in New York at Barclays Plc. The firm is another primary dealer.
“Everyone’s been calling for a sell-off at some point, the logic being yields can’t stay low forever,” Rajadhyaksha said. “You’ll have a hard time finding an economist who says cutting deficits is good for near-term growth.”
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