Thursday, June 2, 2011

Treasury Roars Ahead

By MARK GONGLOFF

The run in Treasurys, defying conventional wisdom, hit a new milestone on Wednesday with the 10-year note's yield falling below 3% for the first time this year despite a looming budget crisis in Washington and end of the Federal Reserve's bond-buying program.

.Those extraordinary factors were offset by the typical driver of Treasury performance—economic growth. Investors rushed into Treasurys on Wednesday after reports of weak data on jobs and factory activity.

The wave of buying pushed trading volume in Treasurys to its highest level since February 2008, according to fixed-income trading platform Tradeweb. The yield on the 10-year note, which moves in the opposite direction of its price, fell to 2.964%, from 3.048% on Tuesday, hitting its lowest level since Dec. 6.

"Every piece of economic data has been dreadfully weak, and it appears as though the economy is facing the potential of a double dip," said Tom di Galoma, managing director at Oppenheimer & Co. "I would certainly bet that another round of QE [quantitative easing] is more likely than a Fed rate hike."

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.The decline in yields on Treasurys, while driven by worries about the economy, will make borrowing cheaper and could help boost the housing market, which has fallen to new lows. Rates on typical 30-year mortgages fell to 4.63%, according to HSH Associates, from a high for the year of 5.32% in February.

The dollar, too, has benefited from rising pessimism about the slowing U.S. economy. The dollar rose 0.37% versus the euro on Wednesday to $1.4340 and is up 3.44% from its low for the year on May 3.

While the slowing economy would be expected to drive yields lower, the Treasury market has two unusual factors working against it: the battle over the debt ceiling in Washington and the end of the Fed's second big bond-buying program, called quantitative easing.

Treasury bears, some of whom have been burned by repeated rallies, say that yields are poised to rise strongly when the Fed at the end of June completes its $600 billion plan to buy Treasurys. They also believe the U.S. government's borrowing is unsustainable and eventually investors will stop buying its debt. A looming showdown over raising the debt ceiling could be the trigger for a selloff.

Among the biggest bears is Pimco's Bill Gross, co-founder of Pacific Investment Management Co., which manages the world's biggest bond fund. Mr. Gross says that once the Fed ends its program, there will be no buyers to step in. In his latest monthly letter to investors, published on Pimco's Website on Wednesday, Mr. Gross compared government-bond holders to frogs being slowly boiled alive, unaware of the dangers of Treasurys.

With their latest rally, Treasurys continue a long track record of defying conventional wisdom. Investors expected Treasury yields to fall when the Fed's latest quantitative-easing program began in November. Instead, they rose. Investors then expected higher Treasury yields this year, as QE ended and the economy recovered. Those expectations were dashed, too.

Treasury investors instead are acting like much of the recent economic growth was driven by government stimulus, and once that is removed, growth will fall. Such a scenario seems to be unfolding. As a result, Treasury yields fell from a peak this year of 3.72% in February, and the market outperformed stocks, corporate debt and inflation-protected securities in May, based on Barclays Capital indexes.

.Treasurys are thriving despite the continuing debt-ceiling debate, which still doesn't seem close to resolution, though the debt ceiling was breached on May 16. The Treasury Department has warned that it might start defaulting on debt in early August, and many observers have warned that the Treasury market could be increasingly agitated as that date approaches.

Just on Tuesday, the House took a largely symbolic vote not to raise the ceiling, and nothing was settled by a meeting Wednesday between President Obama and House Republicans.

Whether the recent decline in Treasury yields has staying power depends on the important economic data the rest of this week, including weekly jobless claims Thursday and Friday's jobs report. "We could give it all back if we get a big number on nonfarm payrolls," said Rich Bryant, head of U.S. Treasury trading at MF Global.

Further economic weakness, on the other hand, could continue to foster talk of another round of quantitative easing from the Fed, which could give Treasurys another boost—at least, that would be the conventional wisdom.

Write to Mark Gongloff at mark.gongloff@wsj.com

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