Ten-year Treasuries overvalued — and then some — but investors buying anyway

U.S. government bond yields are poised to converge with Japan's for the first time in almost two decades, sparking the biggest returns for investors in Treasuries since 2008 while raising concern that America may be stuck in a prolonged period of below-par economic growth. “We are beginning to resemble Japan from an interest-rate policy standpoint as well as potentially an economic growth standpoint,” Bill Gross, who runs the world's biggest bond fund at Pacific Investment Management Co., said in a telephone interview Aug. 10. Investors are “fearful of low growth and are fleeing to high-quality sovereign paper at whatever yield.” Treasuries soared last week after Standard & Poor's cut the U.S. credit rating from AAA, Europe's sovereign-debt crisis deepened and stock markets gyrated, with the Dow Jones Industrial Average rising or falling an average of 3.85 percent each day. The bond rally drove two-year Treasury yields down to a record low and within three basis points of similar-maturity Japanese debt, the smallest gap since 1992, data compiled by Bloomberg show. The outlook for the U.S. economy is so weak that the Federal Reserve took the unprecedented step last week of saying it will keep its benchmark interest rate at almost zero through mid-2013. That promises to bolster demand for Treasuries as the government sells bonds to finance a budget deficit that Congress forecasts will exceed $1 trillion for a third straight year. Estimates Slashed Global financial strains, government fiscal austerity and a lack of jobs led economists to slash their estimates for growth in gross domestic product in 2012 to 2.4 percent, from 3 percent in July, based on the median of 81 estimates in a Bloomberg News survey. Japan's government said last week the nation's GDP may expand 0.5 percent in the year started April 1. Even Gross, who is co-chief investment officer at Newport Beach, California-based Pimco, has been building his holdings of U.S. government debt since eliminating the securities from his $245.5 billion Total Return Fund in February, saying at the time that Treasuries “have little value” because of the nation's growing debt burden and inflation-adjusted yields below zero. The fund had 10 percent of its assets in U.S. debt last month. Treasuries have returned 6.73 percent this year on average, exceeding the 5.88 percent gain for all of 2010 and the most since they rallied 14 percent in 2008. That was the year the economy shrank 3.5 percent as the subprime-mortgage crisis deepened and Lehman Brothers Holdings Inc. collapsed. Yields Tumble The yield on the benchmark two-year Treasury fell last week 10 basis points, or 0.1 percentage point, to 0.19 percent. Ten- year yields tumbled 30 basis points to 2.26 percent, the biggest drop since they tumbled 45 basis points in the period ended Dec. 19, 2008. The yield touched a record low 2.0346 percent. The 10-year yield climbed two basis points to 2.27 percent today as of 9:53 a.m. in New York. Strategists are having a hard time adjusting their forecasts fast enough to keep up with the declines. A Bloomberg survey of 46 economists and strategists released Aug. 12 showed that they slashed their median 10-year yield estimate for the first quarter to 3.10 percent from 3.75 percent in July's poll. “We may end up seeing the lows close to 1.5 percent before the cycle is over,” said David Rosenberg, the chief economist at Gluskin Sheff & Associates in Toronto and the former chief North American economist at Merrill Lynch & Co. Rosenberg said early last month in a radio interview with Tom Keene on “Bloomberg Surveillance” that 10-year notes would “retest the lows in yields we had in 2008.” Relative Yields Treasury two-year yields compare with 0.15 percent in Japan, whose $5.5 trillion economy finally surpassed the previous peak of $5.25 trillion in 1995 last year. The Bank of Japan's benchmark rate has been at 0.55 percent or below since 1995. The Fed has kept its target rate for overnight loans between banks in a range of zero to 0.25 percent since 2008. The spread between two-year U.S. and Japanese note yields has contracted from this year's high of 85 basis points in February. The average over the past 20 years is 214 basis points. Treasuries overall yield about 44 basis points more than Japanese bonds, down from 364 points in July 2007. A financial model created by economists at the Fed that includes expectations for interest rates, growth and inflation indicates 10-year notes are the most overvalued on record. The term premium, which Fed Chairman Ben S. Bernanke cited in a 2006 speech in New York as a useful guide in setting monetary policy, fell to negative 0.41 percent last week. The gauge averaged 0.84 percent this decade through mid-2007. Investor ‘Fear' The last two times the measure was this low, in December 2008 and November 2010, Treasury yields reversed course and started to rise, producing a loss of 3.08 percent in the first quarter of 2009 and 2.67 percent in the fourth quarter of 2010, Bank of America Merrill Lynch indexes show. “There's a fair amount of fear priced into yields,” said Nic Pifer, a money manager in Minneapolis at Columbia Management, which oversees $170 billion. Compared with Japan, “the U.S. economy is a far more vigorous and dynamic economy. It has stronger labor growth over time and better demographics. We are nowhere near the extreme situation that Japan is in. I don't think you want to be a buyer of Treasuries unless you expect the market to continue to experience panic,” he said. Retail sales in the U.S. climbed in July by the most in four months, showing consumers were holding up at the start of the third quarter. The 0.5 percent increase reported by the Commerce Department in Washington on Aug. 12 followed a 0.3 percent gain in June that was larger than previously estimated. U.S. Ratings U.S. bond yields fell even though S&P cut the nation's credit rating on Aug. 5 to AA+ from AAA. The Treasury auctioned $72 billion of three-, 10- and 30-year securities last week at an average rate of 2.13 percent, the lowest on record as measured by Bloomberg data, saving taxpayers $647 million in interest payments during the life of the securities compared with the rates on the previous quarterly refunding. Moody's Investors Service and Fitch Ratings affirmed their top Aaa and AAA grades on the U.S. Treasuries have benefited as investors fled higher-risk assets as stock markets tumbled, Europe's sovereign-debt crisis worsened and economists cut their growth forecasts. Japan, where 10-year notes yield 1.04 percent, shows U.S. bonds may have room to rally further. The nation has the lowest bond yields in the world even though it's rated AA- by S&P, Aa2 at Moody's and AA by Fitch. The country's debt is projected by the Organization for Economic Cooperation and Development to reach 219 percent of GDP by 2012. Bursting Bubble Growth in Japan has been stagnant since an asset bubble burst two decades ago, with the size of the economy at about the same level it was in 1991, when not adjusted for price changes. GDP in the U.S. expanded at a weaker-than-reported 1.3 percent last quarter after 0.4 percent growth in the first quarter. The major difference between the U.S. and Japanese bond markets is that about 95 percent of the Asian nation's bonds are held by domestic investors, according to Tokyo-based Nomura Research Institute Ltd. In the U.S., it's about 50 percent. Last week's Treasury auctions showed direct bidders, a class of investors that are typically U.S.-based, purchased 31.7 percent of the 10-year notes sold, the most in data going back to 2003. Data from the Commodity Futures Trading Commission in Washington show traders reversed bets last week and for the first time since November no longer expect 10-year notes to drop. “Domestic investors are going down that same road that Japanese investors did when they started to buy more local debt,” said George Goncalves, head of interest-rate strategy at Nomura Holdings Inc., one of the 20 primary dealers are obligated to bid at Treasury auctions. “That's a new phenomenon that will be with us for many more quarters. Irrespective of the rate levels, people are willing to own more Treasuries.” --Bloomberg News--