U.S. two-year Treasury yields will fall at a faster pace than those on 10-year notes as the Federal Reserve moves closer to ending its 18-month policy of raising interest rates, say some of the world's biggest bond investors.
Investors are buying two-year notes to lock in yields near the highest since 2001 while anticipating a rally once the Fed stops lifting borrowing costs, satisfied that inflation is being kept under control.
Betting on a wider gap in yields has "been our strategy for the past few months," Bill Gross, who heads the US$90 billion Total Return Fund for Newport Beach, California-based Pacific Investment Management Co., said in a Jan. 3 interview. The Fed is "a little bit closer to the point at which they're going to stop," he said.
The central bank has raised its target rate for overnight loans between banks 13 times since June 2004, to 4.25 percent from 1 percent. The difference in yields between two- and 10-year notes, known as the yield curve, widened last week after the minutes from the central bank's December 13 meeting said the amount of additional rate increases "probably would not be large."
"The Fed is sending the message that they're almost done," said Nasri Toutoungi, who oversees about US$5 billion as managing director of Hartford Investment Management Co. in Hartford, Connecticut. When the market "gets more comfortable about that concept, the two-year could rally" and the 10-year Treasury won't follow, he said in an interview on January 6.
Toutoungi, who expects only one more increase from the Fed, said the yield curve may widen by about a quarter of a percentage point in the next three to six months.
The benchmark two-year note's yield fell 5 basis points last week to 4.35 percent, according to New York-based Cantor Fitzgerald LP. The last time the yield fell more than 5 basis points, or 0.05 percentage point, in a week was the period ended Sept. 2, when Hurricane Katrina struck the U.S. Gulf Coast and investors speculated the Fed would suspend its rate increases. Ten-year yields declined 2 basis points to 4.37 percent.
The yields held at the same levels as of 7:46 a.m. in London. Yields were unchanged in Asian trading as the Bond Market Association recommended markets close in Japan for a holiday.
When the gap between the yields expands, the yield curve is said to steepen. It is said to flatten when the opposite occurs.
"We are taking off our flattening trade," Thomas Seay, who manages US$17 billion at Cleveland-based Victory Capital Management, said in a January 5 interview.
Interest-rate futures show traders are sure the Fed will boost its rate target by a quarter point to 4.50 percent at its Jan. 31 meeting, and they see about a 54 percent chance of an increase to 4.75 percent at the March 28 meeting.
"Views differed on how much further tightening might be required," the Federal Open Market Committee said in the minutes released Jan. 3 in Washington. "Members thought that the policy outlook was becoming considerably less certain."
Two-year yields exceeded 10-year yields by 1 basis point on Dec. 27, inverting the curve for the first time since 2000. Traders attributed the inversion to a drop in trading during the holidays rather than a slowing economy. The daily average of Treasuries traded through ICAP Plc, the largest inter-dealer broker, was about 55 percent of the year's average during the last week of 2005. A Dec. 29 auction of US$20 billion two-year Treasuries also pushed the short-term yields higher.
Last four recessions
The last four U.S. recessions, including the most recent in 2001, were preceded by an inverted yield curve. Inversion occurs when the yield curve is flipped so that short-term debt yields more than longer maturities. Long-term debt yields are usually higher to compensate investors for the extra risk they take in waiting for repayment. Over the past 20 years, 10-year Treasury yields exceeded two-year yields by an average of 93 basis points.
"People say the yield curve is not important," said Marc Seidner, who oversees US$26 billion of fixed-income assets at Standish Mellon Asset Management in Boston. "I'd rather see proof that it's different this time than assuming it will be," he said in a Jan. 6 interview. Seidner said his firm's Treasury investments are evenly distributed across maturities.
The last two times the central bank stopped raising rates, two-year notes rallied and the yield curve steepened.
Yields on two-year Treasuries dropped about 1 percentage point and the gap between two- and 10-year yields widened by about 30 basis points within three months after the Fed ceased raising rates in February 1995.
Two-year Treasury yields fell about 1.6 percentage points after another rate-increase cycle ended in May 2000. By year-end, the yield curve was flat after being inverted by 40 basis points.
Betting yields on two- and 10-year notes would narrow was one of the most reliable trades for Treasury investors the last two years. The difference was 1.15 percentage points at the end of 2004 and 2.42 percentage points at the end of the 2003.
"For most of last year we were looking for the flattener, inversion, with the Fed continuing to raise interest rates," Richard Gilhooly, a senior bond strategist BNP Paribas Securities Corp. in New York, said in a Jan. 6 interview. "The minutes from the December meeting have kind of changed the emphasis. We would look for more steepening."
BNP is one of the 22 primary dealers of U.S. government securities that trade with the central bank's New York branch.
An end to rate increases takes away the main reason for betting on rising two-year yields. The note yielded 2.68 percent on June 30, the day policy makers began lifting rates. The 10- year note yielded 4.58 percent.