U.S. Treasury Investors Trim Bets That Yield Curve Will Flatten

(Bloomberg) -- U.S. Treasury note traders are paring bets that 10-year yields will fall as two-year yields rise, a sign of waning confidence in the Federal Reserve's ability to contain inflation.
``People are no longer convinced that inflation is dead,'' said Tim Policinski, who manages $1.7 billion in bonds at Fort Washington Investment Advisors Inc. in Cincinnati.
Policinski is among investors who ended trades that anticipated a narrowing of the gap between 2-year and 10-year yields after reports showed wages rising at the fastest pace in a year. The government tomorrow may say consumer prices rose 0.4 percent in July, compared with no change in June, according to the median estimate of 55 economists surveyed by Bloomberg.
The gap between yields on two- and 10-year Treasury notes narrowed to 21 basis points from 197 basis points in June 2004, before the first of the Fed's 10 quarter-percentage point interest-rate increases. This year alone the difference shrank by 90 basis points. A basis point is 0.01 percentage point.
The so-called curve-flattening trade has been one of the most profitable bets in the $4 trillion market for Treasuries. An investor may have made about $300,000 for each $10 million in such trades this year, Policinski said. The 3 percent return is about 1 percentage point more than the return on Merrill Lynch & Co.'s U.S. Treasury Master Index.
The yield curve, a chart of the yields of bonds of the same quality and different maturities, hasn't been this flat since 2001. The average the past five years is 155 basis points.
Since the Fed began raising interest rates in June 2004, two- year yields climbed with them. At the same time, 10-year yields declined as higher borrowing costs restrained inflation.
Predictive Powers
Investors and strategists watch the yield curve because of its powers in predicting economic growth. An inversion, when long- term yields fall below short-term yields, preceded each of the past four recessions, and last happened in December 2000.
There is ``a misconception'' to the importance of the yield curve, Fed Chairman Alan Greenspan said in Congressional testimony last month. The yield curve's ``efficacy as a forecasting tool has diminished very dramatically,'' he said.
The curve may range from 25 basis points to 50 basis points the rest of the year, said William Prophet, an interest-rate strategist in Stamford, Connecticut at UBS Securities LLC, one of the 22 primary dealers of U.S. government securities that trade with the Fed's New York branch. John Herrmann, director of economic commentary at Cantor Viewpoint in New York, took off his July call the yield curve will invert.
``A correction seems imminent, and this overcrowded trade will likely end in tears,'' U.S. debt strategists at Lehman Brothers Inc. in New York led by Jeffrey Biby wrote in a report dated today.
`Most Damage'
The yield on the benchmark 4 1/4 percent note due in August 2015 closed at 4.24 percent on Aug. 12, according to bond broker Cantor Fitzgerald LP. The 3 7/8 percent note that matures in July 2007 yielded 4.04 percent.
Faster inflation, which erodes the purchasing power of fixed- income payments, is one reason why long-term bond yields rise. The 10-year note will yield 4.60 percent at year-end and the Fed's interest-rate target will be 4 percent, according to the median estimate in a Bloomberg survey published on Aug. 9.
The Fed will likely keep raising its rate for overnight loans between banks longer than anticipated, said Andrew Harding, director of bonds at Allegiant Asset Management.
``Where will the most damage on the curve be? The five- to 10-year area,'' said Harding, who added his Cleveland-based firm ended yield-curve flattening trades on Aug. 4.
Inversion
The Labor Department on Aug. 5 said worker wages grew 0.4 percent in July, the fastest pace in a year. A week earlier, the government said prices paid by consumers for goods and services excluding food and energy rose 2 percent last quarter. After revisions, it was the fifth quarter at or above that level. The central bank's estimate for inflation on that basis this year is between 1.75 percent and 2 percent.
Rising interest rates and record energy costs may restrain economic growth in 2006, keeping inflation under control, said Lacy Hunt, chief economist at Hoisington Investment Management in Austin, Texas. Crude oil for September delivery ended last week at $66.86 a barrel, up 47 percent from a year ago.
Hoisington is staying invested in longer-term Treasuries on the ``reasonable chance'' the yield curve will invert, Hunt said. The firm's Wasatch-Hoisington U.S. Treasury Fund has returned 14 percent the past year, outperforming 99 percent of similar funds, according to data compiled by Bloomberg.
``If we see an inversion of that curve, that would be a very strong sign that economic activity is going to decelerate sharply and perhaps even fall into a recession,'' he said.
The Fed
After narrowing in the first half of the year, the yield curve traded in a range between 25 basis points and 35 basis points from June 22 to Aug. 11.
``The Fed wants longer rates higher, and it will keep going until it gets what it wants,'' David Brownlee, who manages $7 billion at N.L. Capital Management in Montpelier, Vermont. Brownlee said he took off curve-flattening trades.
The economy will expand at a 4.1 percent annual rate this quarter, the fastest since the first three months of 2004, the median forecast of 66 economists in a Bloomberg survey showed.
When it raised its benchmark rate to 3.5 percent on Aug. 9, the Fed said in a statement that ``spending, despite high energy prices, appears to have strengthened since late winter.'' The central bank also said ``pressures on inflation have stayed elevated.''

To contact the reporter on this story:
Al Yoon in New York at at ayoon@bloomberg.net