Betting on Ben S. Bernanke has been the most profitable trade for government bond investors in 16 years, defying lawmakers in the United States and abroad who said that the Federal Reserve chairman's policies would lead to runaway inflation and the dollar's debasement.
Treasuries due in 10 or more years are up about 28% this year, exceeding the 24.4% gain in all of 2008, during the worst financial crisis since the Great Depression, according to Bank of America Merrill Lynch indexes. Not since 1995, when the securities soared 30.7%, have investors done so well owning longer-dated U.S. government debt.
The rally continued last month, driving yields to record lows in the wake of the Fed's announcement that it would exchange $400 billion of short-term Treasuries for those maturing in more than six years. The move, dubbed Operation Twist by traders, is designed to lower borrowing costs and keep the economy growing.
Previous Fed efforts unlocked credit markets and helped ward off deflation.
Bonds are producing “monster” gains, said Mitchell Stapley, the chief fixed-income officer for Fifth Third Asset Management, which oversees $22 billion.
“I'm dealing with a Federal Reserve with an unlimited balance sheet that is desperately looking for something to do to revive the economy,” he said.
UNEXPECTED RALLY
With the U.S. budget deficit exceeding $1 trillion, this year's rally caught investors by surprise. The lowest forecast among 71 economists and strategists surveyed by Bloomberg News from Jan. 3 to Jan. 11 was for 10-year yields to end the third quarter at 2.35%, and the median estimate was 3.63%.
They closed at 1.83% two weeks ago.
Although a financial model created by Fed economists that includes expectations for interest rates, growth and inflation indicates 10-year notes are the most overvalued on record, investors said that they can't afford not to own government bonds.
Stocks and other assets are falling as Europe's debt crisis deepens, the global economy slows and the Fed commits to keep its target rate for overnight loans between banks at a zero to 0.25% through mid-2013.
“The flight-to-safety bid is still fierce,” said Wan-Chong Kung, a bond fund manager at Nuveen Asset Management, which oversees more than $100 billion. “The fundamentals of very modest growth, modest inflation and a Fed that wants to commit to low rates for a long time continue to be supportive.”
Ten-year Treasury yields fell 21 basis points, or 0.21 percentage points, two weeks ago as the price of the benchmark 2.12% security due August 2021 rose 1 30/32, or $19.38 per $1,000 face amount, to 102 20/32.
The yield touched a record low of 1.67% on Sept. 23. Thirty-year rates tumbled 41 basis points to 2.9%.
Almost all the rally in long-term Treasuries this year has come since the end of June, with the securities up 24.9%. That is the biggest quarterly gain since at least 1978, when the Bank of America Merrill Lynch indexes began tracking the debt.
Treasuries of all maturities are up about 9.3% this year, including reinvested interest, beating 2010's 5.9% as Mr. Bernanke led the Fed in a second round of bond purchases, buying $600 billion of debt from November through June via quantitative easing.
BEATING STOCKS
That is more than the 5.2% return for the global bond market, 3.9% for company debt and 5.6% for U.S. mortgage securities, Bank of America Merrill Lynch indexes show. Gold has gained about 19%, while the MSCI AC World Index of stocks has lost 14.2%, including dividends.
The term premium, which Mr. Bernanke cited in a 2006 speech as a useful guide in setting monetary policy, shows that Treasuries may be poised to fall. The measure declined to -0.67% on Sept. 22, indicating that the notes are expensive when compared with the average 0.84% the past decade through mid-2007, just before credit markets froze.
“These low yields spook investors,” said Larry Milstein, a managing director of government and agency debt trading at R.W. Pressprich & Co. The firm is a fixed-income broker-dealer for institutional investors.
GOP: NO "FURTHER HARM'
Republicans sent Mr. Bernanke a letter last month, asking him not to do “further harm” to the economy by adding more monetary stimulus. After cutting rates, the Fed started buying bonds to inject cash into the economy, purchasing $2.3 trillion of government and mortgage-related securities from November 2008 through June.
“Although the goal of quantitative easing was, in part, to stabilize the price level against deflationary fears, the Federal Reserve's actions have likely led to more fluctuations and uncertainty in our already weak economy,” according to the letter signed by House Speaker John Boehner of Ohio, Senate Minority Leader Mitch McConnell of Kentucky, Sen. Jon Kyl of Arizona and House Majority Leader Eric Cantor of Virginia.
The letter is similar to one that Mr. Boehner and three other Republicans sent to Mr. Bernanke about a year ago, expressing “deep concerns” about the Fed's plan to print money to buy bonds, saying that the central bank risked weakening the dollar and fueling asset bubbles.
Foreign leaders also criticized the policy. Chinese Premier Wen Jiabao said that the plan had caused a “major problem” leading to instability in the currency market, and German Finance Minister Wolfgang Schaeuble said that the policy was “clueless.”
Although the Fed failed to reduce the unemployment rate below 9%, the second round of quantitative easing, or QE2, warded off deflation, which can damage an economy by discouraging investment. Consumer prices excluding food and energy rose 2% in the 12-month period ended Aug. 30, compared with 0.6% in October 2010, the smallest increase since at least 1958, government data show.
Rather than collapsing, the dollar has risen about 2.6% to 78.501 against the currencies of six major U.S. trading partners, including the euro and yen, since the Fed announced QE2 in November, based on IntercontinentalExchange Inc.'s Dollar Index.
“I'm not sure the Republicans' grasp of the Fed and everything that goes with it is particularly strong,” said David Ader, head of U.S. government bond strategy at CRT Capital Group LLC.
“The data confirms the Fed's concerns. If there's uncertainty and a lack of confidence, the focal point is not at the Federal Reserve, but much more in the hands of the people that wrote this letter,” Mr. Ader said.
QE2 followed QE1, which was designed to inject money into the financial system to help unfreeze credit markets. Corporate bond sales worldwide soared to $3.9 trillion in 2009, from $2.9 trillion in 2008, according to data compiled by Bloomberg.
Demand for Treasuries has been fueled by data showing that the economy almost stalled in the first half this year and added no jobs in August, keeping unemployment at 9.1%.
The Organization for Economic Cooperation and Development cut its forecast for growth in the United States to 1.1% for the third quarter and 0.4% for the last three months of the year. Its prior estimates were 2.9% and 3%, respectively.
“This is beginning to look like more of a systematically low-interest-rate world,” said Robert Tipp, the chief investment strategist at Prudential Fixed Income, which oversees $300 billion in bonds. “The outcome for Treasuries is likely to be favorable over the next year or so, unless you get much-stronger-than-expected economic growth.”
"SIGNIFICANT' RISKS
At the close of its two-day meeting Sept. 21, the Federal Open Market Committee cited “significant downside risks” in the U.S. economy and said that it will buy bonds due in six to 30 years through June, while selling an equal amount of debt maturing in three years or less. The purchases “should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative,” the Fed said in its statement.
Policymakers also announced a measure to support the mortgage market by reinvesting maturing housing debt into mortgage-backed securities instead of U.S. government debt.
Even with the rally, the difference between 10- and 30-year Treasury bond yields, at 1.07 percentage points, remains wider than its average of about 0.5 percentage points over the past two decades.
That suggests that the gains in longer-term debt have scope to continue, said Michael Materassoat, senior portfolio manager and co-chairman of the fixed-income policy committee at Franklin Templeton Investments. The firm oversees $298 billion in bonds.
“There's more than one fund manager that wishes they had a lot more allocated to Treasuries,” said Jeff Given, part of a group that manages $18 billion of bonds at MFC Global Investment LLC. “They did much better than anybody would have predicted.”
