Treasuries May Gain This Week On Fed 'Measured' Pace

(Bloomberg) -- U.S. Treasuries are likely to extend a 14-month rally as the Federal Reserve sticks to its ``measured'' pace of interest-rate increases to keep inflation from accelerating after Hurricane Katrina.
Treasuries maturing in 10 years or more have gained as the central bank raised its interest-rate target 2.5 percentage points since June 2004 to keep inflation under control. The benchmark 10-year note's yield has fallen to 4.12 percent from 4.69 percent the day before the Fed started raising rates, lowering borrowing costs for companies and consumers.
After hurricane Katrina caused record damage along the Gulf of Mexico coast, speculation mounted the Fed would pause after 10 consecutive rate increases to assess the economic effects. Interest-rate futures show traders last week renewed bets the Fed will lift rates at its Sept. 20 meeting. A Bloomberg survey showed economists boosted estimates for inflation even as they lowered forecasts for economic growth.
``The Fed is raising rates not because of an acceleration of growth, but because of concerns they have about inflation,'' said Michael Materasso, who oversees $19 billion as head of fixed income at Fiduciary Trust Co. in New York. Additional increases ``would be good for the long end of the market,'' while a pause may send bonds down, he said.
Weekly Loss
The benchmark 10-year note's yield last week rose 8.2 basis points, or 0.08 percentage point, recouping more than half the decline after Hurricane Katrina hit. Chicago Fed President Michael Moskow and San Francisco Fed President Janet Yellen suggested in speeches they are concerned about faster inflation.
The yield on the 10-year note today rose 1 basis point to 4.12 percent as of 9:57 a.m. in Singapore according to bond broker Cantor Fitzgerald LP. The price of the 4 1/4 percent note maturing August 2015 fell 1/32, or 31 cents per $1,000 face amount, to 101 1/32.
The note last week posted its first weekly loss since the five days ended Aug. 5. The 10-year yield rose less than the yield on the benchmark two-year note, which is more sensitive to changes in monetary policy. Two-year yields surged 12 basis points to 3.87 percent.
A Sept. 9 survey of 38 money managers who oversee a combined $1.27 trillion found that 61 percent said the Fed shouldn't pause. Seventy-nine percent in the poll by Jersey City, New Jersey-based Ried, Thunberg & Co. said the risk of faster inflation, which erodes the purchasing power of fixed income payments, would rise without an increase. The survey showed participants expect 10-year notes to fall by year-end.
`Fighting Inflation'
Long-term yields ``have been falling because as the Fed's been raising rates, the market has taken comfort that it's fighting inflation,'' said James Bianco, president of Chicago- based Bianco Research LLC. ``If the Fed pauses, it could produce higher yields.''
How much yields rise depends on how long the respite lasts, Bianco said. Ten-year yields may return to the year's high of about 4.70 percent should the central bank go months without raising rates, he said. Increases at each of the Fed's three remaining meetings this year will likely keep the note's yield between 4 percent and 4.25 percent, Bianco said.
The October federal funds futures contract shows traders see a 78 percent probability of a rate increase next week, up from about 70 percent on Sept. 2. Before the storm, they expected about a 100 percent chance of an increase.
`Stopping Short'
The consumer price index will rise 3.5 percent this quarter, up from a forecast of 3 percent a month ago, according to the median forecast of 54 economists surveyed by Bloomberg between Aug. 31 and Sept. 8. A Sept. 15 government report may show prices, excluding food and energy, increased 0.2 percent last month, in line with the average since 1999, the median estimate in a separate survey showed.
Treasuries maturing in five years or less ``are better value in this environment, with inflationary threats and with the potential of the Fed stopping short of where they would have based upon a slower economy'' resulting from Katrina, said Bill Gross, chief investment officer at Newport Beach, California- based Pacific Investment Management Co. and manager of the world's biggest bond fund.
The economy will expand at a 3.6 percent annual rate from July through September instead of the 4.1 percent predicted a month ago, according to the median estimate of 57 analysts surveyed by Bloomberg from Aug. 31 to Sept. 8.
`Collateral Damage'
Investors such as Marc Seidner, who oversees $26 billion of bonds at Standish Mellon Asset Management in Boston, said the economy is too fragile to withstand higher rates.
``The more the Fed raises interest rates, the higher the probability that there is collateral damage to the economy,'' he said.
Hurricane Katrina destroyed property worth at least $125 billion, according to storm modeler Risk Management Solutions Inc. It shut 10 percent of U.S. refining capacity, pushing gasoline futures to a record $2.6145 a gallon on Aug. 31. The Congressional Budget Office on Sept. 7 said Katrina may cut U.S. jobs by 400,000 this year.
Some investors and Fed officials are concerned that energy prices won't drop and will feed through to so-called core inflation. The Chicago Fed's Moskow said Sept. 7 that core inflation is ``running at the upper end of the range that I feel is consistent with price stability.''
`Pressing Issue'
Yields on Treasury inflation-protected securities, known as TIPS, show expectations for inflation have risen. The difference in yield between 10-year TIPS and fixed-coupon Treasuries widened to a four-month high of 2.48 percentage points. The so-called break-even rate shows the expected pace of inflation over the life of the securities. TIPS pay interest at lower rates than regular Treasuries on a principal amount that increases in line with the consumer price index.
``Of the two main challenges for the Fed, a slight slip in activity versus a pick-up in inflation, we think insuring long- term price stability is the more pressing issue,'' said Jason Evans, head of U.S. Treasury trading in New York at Deutsche Bank AG. The firm is one of the 22 primary dealers of U.S. government securities that trade with the New York Fed.

To contact the reporter on this story:
Elizabeth Stanton in New York at estanton@bloomberg.net