Monday, March 21, 2011

More Volatility Awaits the Treasury Market

More Volatility Awaits the Treasury Market

By MIN ZENG

Turmoil in Japan and the Middle East drove U.S. Treasury debt to its most volatile week in more than a month last week and traders are bracing for further big swings.

Prices are likely to be buffeted by competing forces: Japanese companies and insurers are likely to sell Treasurys as they bring yen home to finance repairs after the devastating earthquake. As the same time, worries that Japan's nuclear crisis could worsen, a well as turmoil in the Middle East, are driving other investors to buy Treasurys, seen as a haven.

A gauge of volatility in U.S. equity markets hit an eight-month high last week, while a similar measure in the Treasury market rose to the highest level since early February.

"Nothing is settled in Japan. Nothing is settled in the Middle East and potentially there are more problems in the euro zone," said Ray Remy, head of fixed-income trading in New York at Daiwa Capital Markets America Inc., one of the 20 primary dealers that trade directly with the Federal Reserve and are obligated to bid on Treasury bond auctions.

Despite a recent European Union agreement intended to address the euro-zone debt crisis, bond market participants fear trouble may flare up again at any time. Portugal's credit rating was downgraded by Moody's Investors Service last week.

Mr. Remy said support for Treasurys will also come from Japan in the near term. Dollars raised as Japan sold yen to drive down the currency are likely to be recycled into the Treasury market, he said. That could bolster demand for Treasury notes to be sold in the last week of this month, especially an auction of two-year debt, he said.

Friday, global stocks gained, while Treasurys and other haven investments fell in response to news that Libya had declared a cease-fire in its struggle against rebel groups, although fighting continued. At the same time, concerted intervention by major central banks to halt the yen's rise eased concern about the world economy.

Yet the problem of radiation from a damaged nuclear plant in Japan remained unresolved. International forces attacked Libya over the weekend, underscoring the uncertainty about the situation there. Yemen declared a state of emergency as the death toll from clashes between government forces and protesters continued to rise.

James Golden, head of Treasury trading in New York at primary dealer Jefferies & Co., expects the benchmark Treasury note's yield, which moves inversely to its price, will fall to near 3% in the next few weeks unless uncertainty about Japan, the Middle East and North Africa abates. The note's yield, which moves inversely to its price, traded at 3.277% Friday, down from the recent peak of 3.77% in early February.

But Toby Nangle, who helps oversee $51.6 billion as director of asset allocation at Baring Asset Management in London, said Treasury yields at the moment don't provide attractive value. He said that Japan's humanitarian and nuclear crisis may not have a big impact on the global economy, adding that the joint intervention by the Group of Seven industrialized nations to weaken the yen is likely to support the Japanese economy.

A stronger yen has dealt added pressure to Japan's economy by making its exports more expensive abroad. The intervention is expected to aid Japanese exporters and boost the country's recovery effort.

James Caron, global head of interest-rate strategy at primary dealer Morgan Stanley in New York, said that the 10-year note's yield hasn't fallen consistently below 3.25%, showing investors don't expect Japan's problems to affect economic growth and inflation expectations, which he said are still "pretty high."

"The market still prices in that we are going to pass Japan and Japan will fix itself," said Mr. Caron. "If anxiety is reduced, you are going to see a pretty big selloff in Treasurys. Fundamentals still support higher yields."

Some big fund managers such as Vanguard Group and Pacific Investment Management Co. are betting that Treasury bond prices will fall in coming months. By the end of February, Bill Gross, Pimco's founder and co-chief investment officer, had dumped all holdings of Treasury notes and bonds in the Total Return Fund, the world's biggest bond fund by assets.

"Once we pass the period of flight-to-quality flows, Treasury yields will rise," said Robert Auwaerter, head of the fixed-income group at Vanguard Group in Valley Forge , Pa. "We position for higher interest rates."

Mr. Auwaerter said the crisis in Japan is unlikely to undermine U.S. economic growth, adding that a rebuilding boom will emerge in Japan in coming months and Japanese investors will sell Treasurys to send funds home for the reconstruction effort.

Write to Min Zeng at min.zeng@dowjones.com

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