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Good News for Bernanke From Bonds Is Bad for Rates (Update3)

By Daniel Kruger and Sandra Hernandez
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April 7 (Bloomberg) -- For the first time since December, the bond market is closing the credibility gap with Ben S. Bernanke and signaling its agreement with the Federal Reserve chairman that an economic collapse has been averted and that interest rates are bottoming. [...]

``There is a sense of stability returning to the market,'' said John Hendricks, who helps oversee $137 billion at Hartford Investment Management Co. in Hartford, Connecticut. ``Bernanke's comments that there's a significant amount of monetary easing already in the system and you've got these other measures coming into play as well that should help the economy rebound in the second half.''

Turning Point

The turning point came when the Fed promised $30 billion to back New York-based JPMorgan's bailout of Bear Stearns, preventing the biggest collapse of an investment bank. The central bank lowered its pledge to $29 billion on March 24 after JPMorgan quadrupled the purchase price to about $2.4 billion.

Treasuries, which tend to perform the best when the economy and inflation are slowing, lost 1.59 percent on average since March 17, according to Merrill's indexes. They had gained 14.5 percent since June 12 as gross domestic product growth slowed to a 0.6 percent annual rate in the fourth quarter, home prices fell 14 percent and bank losses swelled.

High-yield, high-risk corporate bonds returned 2.46 percent following the Bear Stearns rescue, after losing 4.58 percent this year through March 17, the Merrill indexes show.

`Promote Growth'

While acknowledging for the first time that the economy may be in a recession, Bernanke told the Joint Economic Committee of Congress last week that the Fed's actions ``will help to promote growth over time and to mitigate the risks to economic activity.''

The bond market is looking much like it did in December, when yields rose as much as 0.27 percentage point to 3.91 percent on average. The increase followed the Fed's Dec. 11 decision to cut its target for overnight loans between banks to 4.25 percent.

Bernanke is persuading bond investors of his ability to manage the economy after the Fed reduced the target federal funds rate to 2.25 percent, pumped $628 billion through the financial system and allowed securities firms to borrow directly from the central bank for the first time since it was created in 1913.

The difference between what banks and the government pay to borrow is narrowing as confidence starts to return to capital markets frozen by the subprime collapse.

The gap between three-month Treasury bill yields and the three-month London interbank offered rate narrowed to 1.35 percentage points today from 2.03 percentage points on March 19. The spread reached 2.20 percent on Dec. 11 as investors rushed for the security of government debt and banks limited loans to each other, driving up loan costs. [...]

`Easing Mode'

``Much of the bad news has been priced in,'' said Colin Lundgren, head of institutional fixed income in Minneapolis at RiverSource Investments, which manages $100 billion of bonds. ``I'm not sure Treasuries in the next six to 12 months look that appealing, even though we're in a slowdown and the Fed is still in easing mode.''

A weekly survey by Ried, Thunberg & Co. shows that investors who oversee $1.47 trillion expect 10-year Treasury yields to rise by the end of June. The Jersey City, New Jersey- based firm's sentiment index was 48 on April 4, compared with 46 a week earlier. Readings below 50 mean investors anticipate lower prices.

It may be too early to become optimistic about the economy, according to Stuart Spodek, co-head of U.S. bonds in New York at BlackRock Inc., which manages $513 billion in debt.

`Strong Argument'

``The market's perhaps responding to the end of what was perceived to be a liquidity crisis or credit crunch,'' he said. ``You can make a very strong argument based on the chairman's comments and some of the data that the fundamental picture and the real economy picture haven't improved.''

The economy may expand 2.1 percent in the third quarter, from 0.55 percent this quarter and 0.2 percent in the first three months of the year, according to the median estimate of 85 economists surveyed by Bloomberg.

Traders see a 36 percent chance the Fed will lower rates by a half-percentage point to 1.75 percent at its next scheduled meeting on April 30, down from 52 percent a week ago, according to interest-rate futures contracts on the Chicago Board of Trade.

Treasuries even fell on April 1, when UBS AG, Switzerland's biggest bank by assets, reported $19 billion of credit costs, and Deutsche Bank AG, Germany's largest bank, said it will write down $3.9 billion of loans and asset-backed debt.

``We're losing a little of the safe-haven bid,'' said Hendricks. ``Time will tell as to whether people are jumping the gun here or whether there's going to be another leg down, but for the moment the markets have definitely calmed down.''

To contact the reporter on this story: Daniel Kruger in New York at dkruger1@bloomberg.net; Sandra Hernandez in New York at shernandez4@bloomberg.net
Last Updated: April 7, 2008 10:26 EDT