JUL 15, 2013 10:42am ET

Bernanke Boom Signaled by Yield Surge as Market Recalculates

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The worst first half for Treasuries in four years has wrung the unprecedented Federal Reserve stimulus out of bond prices as investors now look to low inflation and slow economic growth to contain yields.

While yields on 10-year Treasuries rose to 2.58% last week from as low 1.61% in May, the term premium, which measures the risk of holding longer dated bonds by incorporating investors’ outlook for inflation and growth, suggests they are no longer overvalued.

“We actually just bought Treasuries because we think we are pretty close to that equilibrium price,” Jack McIntyre, a money manager who oversees $44.5 billion at Brandywine Global Investment Management LLC in Philadelphia, said in a July 9 telephone interview.

The term premium reached 0.46% this month, compared with the 0.4% average in the decade before the 2007 financial crisis and the Fed’s efforts to pump cash into the economy by purchasing bonds, according to Columbia Management Investment Advisers LLC. As recently as May, the measure was at minus 0.5%.

Bond bulls say the highest inflation-adjusted yields since March 2011, the slowest pace of increases in consumer prices since 2009 and below-average economic growth will support debt markets. The head of BlackRock Inc., which manages about $4 trillion, and other bears say signals by the Fed that it could begin trimming the $85 billion it spends every month buying bonds this year, coupled with the fastest job gains since 2005 and stock indexes at record levels will diminish demand for fixed-income assets.

“If you look at inflation, the kryptonite for bond guys, we just don’t see it,” Brandywine Global’s McIntyre said. “We’ve gone through an adjustment where yields have gone higher. I don’t think yields will go significantly higher to entice” investors, he said.

The personal consumption expenditure deflator, the Fed’s preferred gauge of inflation, rose 1% in May from a year earlier, compared with a 0.7% rise in April that was the smallest since 2009.

Bond yields have advanced from 2.19% on June 18, the day before Fed Chairman Ben Bernanke said the central bank may start dialing down its unprecedented bond-buying program this year and end it entirely in mid-2014 if the economy finally achieves the sustainable growth the central bank has sought since the recession ended in 2009.

The increase in yields contributed to a 2.48 percent loss in Treasuries for the first half of the year, the most since 2009, according to Bank of America Merrill Lynch index data. At the same time, the Standard & Poor’s 500 Index of U.S. stocks has risen 6.8%, erasing a 5.8% plunge from May 21 through June 24 that was based on speculation that any withdrawal of stimulus by the Fed would hurt the economy.

Yields reached 2.75% on July 8, the highest since August 2011. They fell 16 basis points last week, or 0.16%, the biggest slide since the period ended June 1, 2012, as the benchmark 1.75% note due May 2023 rose 1 10/32, or $13.13 per $1,000 face amount, to 92 25/32.

Yields on 10-year securities rose one basis point, or 0.01 percentage point, to 2.59% at 10:31 a.m. London time today.

Real yields, after subtracting the annual inflation rate, are 1.56 percentage points, about the most since March 2011. As recently as November, real yields were negative.

Term premiums show “there’s really not a valuation case against Treasuries,” Zach Pandl, a strategist and money manager at Columbia Management, which oversees $340 billion, said in a July 10 telephone interview.

In a developed market economy with slow inflation, a term premium of 50 to 75 basis points is normal and “at 40 basis points you’re approaching fair value,” said Pandl, who has developed models for the gauge. The rise in the measure after Bernanke’s comments shows Fed policy was “the single most important factor” in pushing the gauge below zero, Pandl said.

The term premium turned positive June 19 for the first time since October 2011, according to Columbia Management. A negative number showed that investors were willing to own bonds at such expensive levels as long as the Fed was buying. A positive one signals they are now demanding more in yield as the central bank steps back and the market reacts more to the economic outlook.

Economists and strategists see little change in yields for the remainder of 2013, ending the year at 2.62 percent, based on the median of 67 estimates in a Bloomberg survey. That’s below the average yield of 5.37% over the past 25 years.

“It’s going to be hard to sell-off unless something dramatically changes, which we don’t forecast over the next couple of months,” Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York, one of 21 primary dealers that trade with the Fed, said in a July 10 telephone interview.

Treasury 10-year note yields have probably established a new range between 2.4% and 2.75%, Jersey said.

Bond bears say an improving economy will allow the Fed to reduce bond buying this year and end it next year.

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