Demand Still Strong in 'Belly of the Curve'

--5 or 1o year Trea might still hold up and outperform as economy weakens further and government continues its effort to buy mortgage securities By DEBORAH LYNN BLUMBERG After the Treasury market's rally last year, investors might feel there is little scope for more gains. Not so, say some investors. They are setting their sights on the five- and 10-year sectors, referred to as the belly of the curve. These sectors should outperform as the economy weakens further and the U.S. government continues its efforts to heal the financial system and get growth back on track. These sectors also stand to gain from the government's purchases of mortgage-related debt issued or guaranteed by mortgage giants Fannie Mae and Freddie Mac. Five- and 10-year notes are popular hedging tools for mortgage-bond investors, who buy these notes to keep their portfolios balanced. Short-term Treasurys such as two-year notes, however, have less room for gains, given that official rates are set to remain in the zero to 0.25% range for the time being. The preference for intermediate Treasurys was already evident, with the five-year note gaining 10/32 points, or $3.125 for every $1,000 invested, to yield 1.526% and the 10-year note yielding 2.409% Friday. Bond prices move inversely to yields. "I see nothing on the horizon that's threatening to the market, and rates are probably going to improve," said David Ader, head of government bond strategy at RBS Greenwich Capital. There is another trade that allows investors to take advantage of the bifurcating outlook for government debt: a flatter yield curve. Mr. Ader expects the benchmark yield curve, the gap between the two- and 10-year yields, to continue to flatten this week, reaching 1.55 percentage points from Friday's 1.64 points. The curve hit a peak of 2.62 points in mid-November. Data this week should support the government-bond market, with December retail sales expected to slide and regional manufacturing data to deteriorate further. The Federal Reserve also will continue its purchases of agency and mortgage debt. It has pledged to buy $100 billion in agency debt and $500 billion in mortgage-backed debt. And then there is the market for Treasury Inflation-Protected Securities, or TIPS. These securities have fallen sharply relative to cash bonds, given the pervasive concerns that the weak economy could result in a prolonged and broad decline of prices. But many investors are worried that the Fed's moves to keep cash flowing to the economy through a variety of lending programs could result in inflation down the road. "There's a lot of money being printed," Mr. Ader said. Write to Deborah Lynn Blumberg at deborah.blumberg@dowjones.com