Bernanke's tactics spell more misery in Treasury bonds

By Daniel Kruger  |   2008-7-1  |     NEWSPAPER EDITION

THE biggest bear market in Treasuries since 2004 may get worse.

Unlike four years ago, when Federal Reserve Chairman Alan Greenspan embarked on 17 interest-rate increases to contain the threat of rising consumer prices, his successor Ben S. Bernanke is giving investors few assurances that inflation will abate soon.

"The Treasury market going forward is more an inflation story," said Colin Lundgren, head of institutional fixed income for RiverSource Institutional Advisors in Minneapolis, which manages US$100 billion in bonds. RiverSource is reducing Treasuries in favor of securities backed by commercial mortgages and investment-grade corporate debt, he said.

Investors have lost 2.2 percent on average since March, including reinvested interest, according to Merrill Lynch & Co's Treasury Master Index. That's the worst performance since the second quarter of 2004, when they tumbled 3.1 percent, said Bloomberg News.

Based on past years when the Fed, like now, was grappling with faster inflation and concern about turmoil in credit markets was starting to ease, investors might not enjoy a rebound.

In the second halves of 1994 and 1999, United States government debt returned less than 1 percent. In the first case the Fed increased interest rates in response to inflation threats, while in 1999 the collapse of hedge fund Long-Term Capital Management LP the year before failed to bring down the economy.

As recently as June 23, Treasuries were down 3.27 percent for the quarter, the most since the three months ended September 30, 1980, when they tumbled 5.1 percent. Back then, Fed Chairman Paul Volcker was raising rates to stamp out inflation.

Treasuries then recovered some of their losses as the Fed ended the most aggressive series of rate cuts in two decades and gave no indication that it will soon raise borrowing costs. That caused traders to pare bearish bets they placed in anticipation that policy makers would be more hawkish.

"Investors believe that future moves by the Fed are likely to be tightenings rather than easings," said Jane Caron, chief economic strategist in Vermont, at Dwight Asset Management Co. The firm oversees US$70 billion of bonds.

The yield on the 2.875-percent note maturing in June 2010 fell 27 basis points last week to 2.63 percent, according to BGCantor Market Data. The yield on the benchmark 10-year Treasury, a 3.875-percent note due in May 2018, dropped 20 basis points to 3.97 percent. Yields were little changed yesterday.

Even with the rally, managers, overseeing US$1.37 trillion, cut their holdings of Treasuries to 30 percent of assets last Friday from 34 percent two weeks earlier.