=DJ OFF THE RUN: Supply Surge The Antidote For Low Yields?
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By Steven C. Johnson
A DOW JONES NEWSWIRES COLUMN
NEW YORK (Dow Jones)--For Treasury investors, 2006 may prove a year for strong stomachs.
An expected widening of the fiscal budget gap and a slew of maturing notes and bonds all but guarantee a deluge of new supply this year to meet the government's cash needs.
That could cause some market indigestion, analysts say, and possibly push long-term rates higher across the curve.
"I don't think it will be enough to force the 30-year bond up 200 basis points, but it will result in a gradual increase across the curve," said Gina Martin, financial economist at Wachovia Securities in Charlotte, N.C.
That would reverse the bewildering trend seen over the last year in which yields on the back end remained stubbornly low despite a steady rise in short-term rates.
"We're going to see an increase in supply, no question, and that means prices down and yields up," said Gary Pollack, managing director at Deutsche Bank Private Wealth Management in New York.
A pivotal Federal Open Market Committee meeting on Jan. 31 that investors hope will provide clear signs about the future course of short-term rates and key data on economic growth make the weeks ahead even more crucial for the market.
Supply Surge
In a research report dated Jan. 25, analysts at UBS in Stamford, Conn. estimate Treasury will have to raise $800 billion in fiscal year 2006 - $175 billion in the first quarter alone.
Some $49 billion will come in next month's quarterly refunding, spread out across three-, 10- and 30-year debt, UBS estimates.
The Bond Market Association, which represents the interests of fixed-income investors, said Wednesday that respondents in a recent survey are projecting the Treasury to sell $169 billion in debt during the first three months of the year.
Indeed, Wednesday's sale of $22 billion in two-year notes pushed yields up across the curve, moving both the two- and 10-year yields to multi-week highs.
And borrowing needs aren't likely to lighten as the year wears on. The government has said it expects its fiscal deficit to widen this year after narrowing a bit in 2005, partly the result of spending increases tied to rebuilding along the Gulf coast; UBS expects a $55 billion deterioration.
Also, a sharp rise in redemptions - UBS estimates some $450 billion in notes and bonds will mature in this fiscal year - will heap further pressure on Treasury to secure new sources of funding.
Another key factor: an expected decline in municipal refundings. When state and local governments refinance outstanding debt, they typically buy custom-made Treasurys, known as SLGS, and use the income to pay off old bonds.
This decreases Treasury's own funding needs by reducing the amount of debt it must sell. Deutsche's Pollack said refinancing activity in 2005 was robust, clocking in at roughly $130 billion.
But since local governments can only refinance outstanding debt once, this activity is expected to fall off in 2006, putting a greater onus on Treasury to raise money.
All of that could offset the trend of low yields and a flat to inverted yield curve, which economists have blamed on myriad culprits, from heavy overseas Treasury buying to central bank transparency and export-led growth by emerging market economies like China, which soak up excess inflation by flooding global markets with cheap goods.
"Supply could very well be the factor that drives rates higher, and it's certainly not a small factor, but - and this is a big 'but' - if the U.S. economy slows in the coming year," all bets are off, said Mary Ann Hurley, vice president of fixed income trading at D.A. Davidson in Seattle.
Indeed, economists are predicting slower U.S. growth in 2006, and if that causes the Fed to end the monetary tightening campaign it began in mid-2004, investors will likely flock to bonds and offset the supply-related pressure on yields.
Put another way: "Overall, Fed policy and where the economy is going is the overriding factor that will drive where interest rates are headed," Hurley said.
One thing that could slow the economy and stay the Fed's hand sooner rather than later is a slowdown in the U.S. housing market and the damping effect it's expected to have on consumer spending, she said.
Different This Time
But some insist 2006 is likely to be the year of at least slightly higher rates. Martin said Wachovia is forecasting a yield of 5% on the 30-year Treasury bond by year end from the current 4.65%.
And "I certainly don't think we're looking at a scenario where the 10-year note is trading at 4.40% again at the end of the year," she added, referring to the note's 2005 year-end level.
The 10-year note opened 2005 yielding 4.21% and closed less than 20 basis points higher, despite a Fed tightening campaign that pushed the overnight fed funds rate up 200 basis points over the course of those 12 months. It's currently yielding 4.48%.
Martin said a surge in new supply will give investors a chance to trade away from the benchmark 10-year note toward other securities. And the first 30-year bond auction since 2001, slated for Feb. 9, could prompt a shift away from the 10-year note as well, especially by pension fund mangers to whom the new longer bonds will appeal as a safe and long-duration investment, she said.
Futures markets widely expect the Fed to raise short term rates for the 14th straight time on Jan. 31 from 4.25% to 4.50%, but opinion after that is split.
In any case, many investors have noted that even one more move will probably result in the Treasury curve from short-term bills to 10-year notes trading below the overnight lending rate.
This would create an uncomfortable and rare situation known as "negative carry," meaning that borrowing short-term funds will cost more than those funds, reinvested in long-term Treasurys, will return. In the past, that has only happened when the Fed was on the verge of cutting rates.
"While it is difficult to maintain this view, we continue to think that carry dynamics will ultimately push rates higher," bond strategists at UBS wrote in a research note Wednesday. "We are not among those who think the Fed will go 'too far' in its tightening cycle, and we certainly don't believe they have already done so."
Rather, UBS is calling for a pause after Jan. 31.
Respondents to a Bond Market Association survey expect the 10-year yield to rise to 4.75% by the end of the quarter, with a two-year note yield keeping pace and rising to 4.70% from 4.46% Wednesday. |
