Treasury Volatility Approaching Four Year Lows as Bonds Rally

Price swings in the Treasury market are approaching the smallest levels in four years, a sign that the end of the Federal Reserve’s $600 billion bond-purchase program next month won’t cause a sell-off in government debt.

The Merrill Option Volatility Estimate, or MOVE, index fell to 74.80 basis points on April 25, within 0.7 of its lowest level since July 2007, just before credit markets seized up and led to the worst financial crisis since the Great Depression. The index is down from a 12-month high of 125.2 on Dec. 15.

For all the concern over the $1.3 trillion budget deficit and a warning from Standard & Poor’s that the U.S.’s AAA credit rating is in jeopardy, Treasuries posted the best returns in eight months during April, gaining 1.15 percent, according to Bank of America Merrill Lynch indexes. Investors were reassured by Fed Chairman Ben S. Bernanke, who said he’s in no hurry to raise interest rates and that he will keep reinvesting proceeds of maturing debt held by the central bank in bonds.

“Volatility is showing the market is not worried about a massive yield spike” said Laird Landmann, a managing director at TCW Group Inc., which oversees $65 billion in fixed-income assets. “The market has given the Fed latitude to be deflation fighters rather than inflation fighters right now.”

The Fed began a second round of asset purchases that’s been dubbed quantitative easing, or QE2, in November after buying $1.7 trillion in securities through last year to help prevent deflation by increasing the amount of money in circulation. The Fed has been buying about $75 billion of Treasuries a month in a program that will end next month.

Falling Yields

The U.S. is counting on the confidence of domestic and foreign investors to remain high as it sells record amounts of debt to finance the deficit.

Yields on Treasuries have fallen to an average of 1.81 percent from 5 percent in mid-2007 even though the amount of marketable Treasury securities has risen to $9.14 trillion from $4.34 trillion, Bank of America Merrill Lynch indexes show.

The Treasury Department — which is scheduled to auction $72 billion of 3-, 10- and 30-year bonds at its so-called quarterly refunding in coming days — got a boost last week as commodities tumbled and investors sought the safest assets.

The yield on the benchmark 10-year note fell 14 basis points, or 0.14 percentage point, to 3.15 percent, the lowest level on a closing basis since Dec. 7, based on Bloomberg Bond Trader Prices. The price of the 3.625 percent note due February 2012 rose 1 6/32, or $11.88 per $1,000 face amount, to 103 31/32.

The yield was 3.16 percent today at 9 p.m. in New York.

‘Left Behind’

Yields have plunged from the highs this year of 3.77 percent on Feb. 9 on concern rising energy and food costs will restrain the economy after U.S. gross domestic product expanded at a 1.8 percent annual rate last quarter. That’s the slowest pace since the three months ended June 30.

“Our economy is far from where we would like it to be, and many people and neighborhoods are in danger of being left behind,” Bernanke said in a speech in Arlington, Virginia, on April 29. “The broader economy is in a moderate recovery.”

The central bank will keep its target rate for overnight loans between banks in a range of zero to 0.25 percent through year-end, according to the median estimate of 80 economists surveyed by Bloomberg News. A separate poll shows they expect 10-year yields to remain below 4 percent in 2011.

Fed Driving Volatility

“The primary driver of volatility right now is Fed policy,” said Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch in New York, one of the 20 primary dealers that trade with the Fed. “The hurdle to a hike seems high because of the growth picture and the hurdle to ease is high because of inflation concerns.”

Volatility averaged 90.75 basis points in the five years before June 2007, as measured by the MOVE index, which tracks price swings based on over-the-counter options maturing in 2 to 30 years. The index then soared to a record 264.6 following the collapse of Lehman Brothers Holding Inc. in September 2008. It rose to 84.1 percent on May 6.

While the debt market may be sanguine, the world’s biggest bond investor said last week that relatively low yields on Treasuries fail to compensate for the risks of the securities.

‘Abdication of Responsibility’

“There should be little doubt that simply holding Treasuries at these yield levels for an extended period of time represents an abdication of responsibility,” Bill Gross, who runs the $240.7 billion Pimco Total Return Fund, wrote in his monthly investment outlook letter. Bond investors “are being shortchanged by 1 percent to 2 percent annually compared to historical norms,” he wrote.

Gross, who is also the co-chief investment officer at Newport Beach, California-based Pacific Investment Management Co., began to bet against U.S. government-related debt in March and made cash the largest holding of the Total Return Fund.

S&P put a “negative” outlook on the U.S. AAA credit rating April 18, saying there’s a one-in-three chance of a downgrade unless lawmakers agree on a plan by 2013 to reduce budget deficits and the national debt. Congress is debating raising the government’s $14.29 trillion limit, which the Treasury predicts will be reached this month.

Demand Sustained

So far, there’s been no sign of waning demand. Treasury has received $2.97 in bids for every dollar auctioned this year, little changed from last year’s record $2.99, Treasury data show. The U.S. has sold $713 billion of notes and bonds this year, compared with $812 billion at this time in 2010.

Purchases are being helped by commercial banks buying U.S. government securities at the fastest pace since July, or $68 billion over the past two months, boosting their total stake to $1.683 trillion, Fed data show.

The Fed has also been the dominant buyer of Treasuries sold at recent auctions, making the central bank the world’s biggest holder of U.S. government debt. More than 36 percent of the Treasuries the Fed bought in March were issued within the previous 90 days, up from 15 percent in November, according to Bank of America Merrill Lynch.

International demand is also picking up. The Fed’s holdings of U.S. government debt on behalf of foreign central banks and institutional investors jumped to $2.691 trillion as of May 4, up 3.58 percent from this year’s low of $2.598 trillion on Jan. 19. That compares with no change in the previous 11 weeks.

Bearish to Neutral

The most bearish primary dealer, Morgan Stanley, as well as Goldman Sachs Group Inc., has dropped recommendations to bet against Treasuries as economic growth slows.

“We have recently turned neutral from bearish on bonds,” James Caron, head of U.S. interest rate strategy at Morgan Stanley in New York, wrote in a report last week.

Goldman Sachs, also based in New York, abandoned its call for investors to set up trades that would profit from a drop in five-year notes, Francesco Garzarelli, the firm’s London-based chief interest-rate strategist, wrote in a report.

“Right now we’re keeping monetary policy accommodative,” Eric Rosengren, president of the Federal Reserve Bank of Boston, said in an interview on Bloomberg Television May 5. Asked whether a third round of quantitative easing was under consideration, Rosengren said that “nothing’s off the table, it depends on economic conditions, so we have to do whatever makes sense given our outlook for the economy.”

A bond market measure of inflation expectations the Fed uses to help determine monetary policy was at 2.93 percentage points, compared with 2.82 percentage points on March 23. It reached a 10-month high of 3.28 percentage points in December. The five-year, five-year forward break-even rate projects what the pace of consumer price increases may be, beginning in 2016. It averaged 2.78 percentage points over the past five years.

“Until there are significant worries about inflation and a bigger pickup in growth the Fed is under no pressure to move,” said William Cunningham, co-head of global active fixed-income in Boston at State Street Global Advisors, which oversees $2.1 trillion.

To contact the reporter on this story: Cordell Eddings in New York at ceddings@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net