Wednesday December 22, 3:59 pm Eastern Time
ANALYSIS-Worst losses for Treasuries may be over
NEW YORK, Dec 22 (Reuters) - Bearish market conditions lie ahead for U.S. Treasuries, but the worst of the losses may be over if the Federal Reserve can engineer a gradual slowdown in economic growth, economists said.
That means Treasuries could spend another year as a wallflower while investors choose higher yielding debt instruments and alluring technology stocks over plain-Jane government securities.
Analysts expect yields to rise moderately in early 2000 and ease a bit near year end, finishing at levels modestly higher than those prevailing in late December 1999.
That scenario presumes that the Fed will raise interest rates once or twice in the first half of the year and that tighter credit will slow the economy later in 2000.
''Modest losses will be followed by equal gains so there will not be a major change in yields, but it will still be a welcome improvement from 1999,'' said Peter Kretzmer, senior economist at Bank of America Securities.
A median forecast of the Bond Market Association's (BMA) Economic Advisory Committee was for the benchmark 30-year long bond yield to rise to 6.7 percent by year-end 2000.
Those yields assume a modest decline in Treasury prices in 2000, in marked contrast to the sharp losses seen this year. Prices have tumbled more than 6 percent, pushing up the yield, which moves in the opposite direction, 137 basis points to 6.47 percent on Wednesday from 5.10 percent at the end of 1998.
SPREAD PRODUCT, STOCKS TO COMPETE WITH TREASURIES
As they did in the year now ending, Treasuries will face competition from higher-yielding agency and corporate fixed-income instruments and from headline-grabbing stocks.
''Rarely has the contrast between equity and bond market performances been as sharp as it was in 1999,'' said Henry Willmore, senior economist at Barclays Capital.
As bond prices fell this year, posting their worst performance since 1994, stocks soared. The blue-chip Dow Jones Industrial Average rose 22 percent, the Standard & Poor's 500-stock index climbed 17 percent, and the technology heavy Nasdaq index soared 78 percent.
In contrast, Merrill Lynch's U.S. Treasury Master index had a -2.2 percent total return in 1999 as of the December 21 close. Its U.S. Corporate Bond Master index did marginally better, producing a total return of -2.0 percent.
''Bond yields will be under a bit of upward pressure as the Fed tightens, but spread product is looking pretty attractive relative to Treasuries because the odds of a near-term recession are slim,'' said Joshua Feinman, chief economist at Deutsche Asset Management Americas.
SOFT LANDING SCENARIO
On Wall Street and Main Street, a strong consensus exists that the nine-year-old economic expansion will continue through 2000, though at a slower pace than in recent years.
The BMA predicted gross domestic product (GDP) growth would slow to 3.0 percent in 2000 from about 3.9 percent this year.
The main risk for investors in spread product would be an economic slowdown, Feinman said.
Even then, debt issued by government sponsored agencies like Fannie Mae (NYSE:FNM - news) would weather a recession better than corporates, thus remaining more attractive to fixed-income investors than lower-yielding Treasuries, Feinman said.
SHRINKING SUPPLY, HARD LANDING OR STOCK SLIDE
Three factors could help the Treasury market -- shrinking supply, the potential for a hard landing, and the possibility of a stock market decline, analysts said.
Of these, the first is the one investors can count on most. Federal budget surpluses allow U.S. Treasury to cut issuance. The inflation adjusted fourth-quarter to fourth-quarter fiscal year federal budget surplus was $69 billion in 1998 and should total $138 billion in 2000, according to the BMA.
''It's a matter of scarcity,'' said Willmore.
A major stock market slide would also renew investors' appreciation for the safety of U.S. government securities.
A stock market decline would reduce the risk of additional Fed tightening and cause a flight to quality, said Willmore.
''Right now you're seeing much higher returns elsewhere, but as ... these (Treasury) yields get more attractive, and if the Fed starts talking about the wealth effect and how they're going to raise interest rates, all that could change,'' said Lehman Brothers economist Joel Kent.
''The soft landing is the highest probability scenario, but if we slow down more than that, it could be a very friendly environment for Treasuries,'' Kretzmer said.
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