Treasury Yield Curve Flattens Amid Fed Rate Speculation
Daniel Kruger and Susanne Walker

The Treasury yield curve approached the flattest level in almost five years as investors speculated the Federal Reserve may raise interest rates sooner than forecast.

Longer-maturity bonds have outperformed this week as signs the U.S. recovery is uneven helped bolster demand for safer assets with extra yield. The difference between five- and 30-year yields fell toward the narrowest since 2009. Gilts dropped after Bank of England Governor Mark Carney said yesterday that the bank may raise its key interest rate earlier than investors expect.

"You have a hawkish statement out of a central bank," said Ira Jersey, an interest-rate strategist in New York at Credit Suisse Group AG, one of 22 primary dealers that trade directly with the Fed. "That could mean the Fed may not be too far behind. Threes and fives have to start pricing for that. That part of the curve is vulnerable to hawkish central bank policy."

The 30-year yield was little changed at 3.41 percent at 12:03 p.m. New York time, according to Bloomberg Bond Trader data. The 3.375 percent bond maturing in May 2044 fell 2/32, or 63 cents per $1,000 face amount, to 99 1/4. The yield fell two basis points this week.

Yields on benchmark Treasury 10-year notes added one basis points to 2.61 percent to push the weekly gain to two basis points. Three-year yields rose two basis points to 0.94 percent after touching 0.96 percent, the highest since Sept. 6, and are up 11 basis points this week.

Yield Curve

Five-year yields added two basis points today to 1.70 percent and headed for a six basis-point weekly increase. The yield spread between five-year notes and 30-year bonds shrank to as narrow as 168 basis points today, after contracting to 167.8 on May 2, the least since September 2009.

Shorter maturities are more sensitive to what the Fed does with interest rates, and futures contracts show traders are betting policy makers will raise borrowing costs in 2015. Longer-dated debt is more influenced by the outlook for inflation.

The spread widened after wholesale prices in the U.S. unexpectedly fell in May. The 0.2 percent decrease in the producer price index (SPX) compared with the median estimate in a Bloomberg survey of 71 economists that called for a 0.1 percent gain. Over the past 12 months, costs climbed 2 percent, figures from the Labor Department showed today.

Confidence Drops

Treasuries pared losses after the Thomson Reuters/University of Michigan preliminary sentiment index unexpectedly fell to 81.2 for June from 81.9 the previous month, a Bloomberg survey showed before the report. Economists in a Bloomberg News survey had forecast the index would rise to 83.

Retail sales advanced 0.3 percent in May, the Commerce Department said yesterday, half the gain projected by economists. Import prices, another gauge of inflation, increased 0.1 percent, also half the increase predicted.

The Fed is reducing its monthly bond purchases, while keeping the target for overnight lending between banks in a range of zero to 0.25 percent. Policy makers signaled at their April 29-30 meeting that interest rates will stay low for a "considerable time." They next meet on June 17-18.

The central bank's exit from stimulus has the potential to be problematic, Fed Reserve Bank of Boston President Eric Rosengren said in a speech in Guatemala City on June 9. That fueled speculation officials are more actively considering the process of policy normalization, according to DZ Bank's Cossor.

The chance of a rate increase to 0.5 percent or more by the end of next year is 71 percent, according to data compiled by Bloomberg based on federal fund futures.

Geopolitical Risks

The Standard & Poor's 500 Index of shares fell the most in three weeks yesterday after President Barack Obama said he would't rule out using air strikes to help Iraq's government battle Islamic militants who threaten to ignite a civil war.

"The data remains very soft, and the geopolitical risks are just too great at this point to not be involved in U.S. government bonds," said Thomas di Galoma, head of fixed income rates at ED&F Man Capital Markets in New York. "There could be more issues out of Iraq over the weekend, so you're starting to see the shorts take some chips off the table." Shorts are bets that the price of a security will fall.

Oil for July delivery climbed to as high as $107.68 a barrel in electronic trading on the New York Mercantile Exchange, the most since September. The average over the past decade is about $79.

The Bloomberg Global Developed Sovereign Bond Index (BGSV) returned 4 percent this year through yesterday, compared with a 4.6 percent loss in 2013.

To contact the reporters on this story: Susanne Walker in New York at swalker33@bloomberg.net; Lucy Meakin in London at lmeakin1@bloomberg.net; Daniel Kruger in New York at dkruger1@bloomberg.net

To contact the editors responsible for this story: Robert Burgess at bburgess@bloomberg.net Kenneth Pringle, Paul Cox

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