Real Yields Highest Since ‘94 Aid Treasury $115 Billion Auction

July 27 (Bloomberg) -- The highest inflation-adjusted yields in 15 years are helping provide the Treasury with record demand at auctions as the U.S. prepares to sell $115 billion of notes this week.

Treasuries are the cheapest relative to inflation since 1994 after consumer prices fell 1.4 percent in June from a year earlier. The real yield, or the difference between rates on government securities and inflation, for 10-year notes was 5.06 percent on July 24, compared with an average of 2.74 percent over the past 20 years.

The gap helps explain why investors are buying bonds after losing 4.8 percent this year, the steepest decline on record, according to Merrill Lynch & Co. indexes that date back to 1978. While Treasury will probably sell an unprecedented $2 trillion of debt this year, Federal Reserve Chairman Ben S. Bernanke said last week that limited inflation pressures will allow policy makers to keep interest rates near zero.

“Concerns surrounding rising Treasury supply to fund the various U.S. stimulus programs are overblown,” strategists led by Brad Henis in New York at Citigroup Inc., one of the Fed’s 17 primary dealers required to bid at the auctions, wrote in a July 23 research report.

The government is selling $6 billion of 20-year Treasury Inflation Protected Securities, $42 billion of 2-year notes, $39 billion due in 5 years, and $28 billion of 7-year notes through July 30. It’s only the second time that three so-called coupon issues and TIPS will be sold in a single week since the regular sales began in 1976. The previous record was $104 billion in 2-, 5-, and 7-year debt the week of June 22.

Bernanke Rally

Bernanke’s testimony on the economy and monetary policy before Congress last week helped ease concern that efforts by the central bank and the administration of President Barack Obama to end the worst recession in half a century will spark faster inflation.

Treasuries rallied as Bernanke’s spoke, with the yield on the benchmark 3.125 percent note due May 2019 declining 12 basis points, or 0.12 percentage point, to 3.48 percent on July 21. Bonds ended the week little changed at 95 19/32 to yield 3.66 percent in New York, according to BGCantor Market Data.

Citigroup recommends buying 10-year notes when yields approach 4 percent and selling them when they move closer to 3.25 percent. Rates on benchmark 10-year notes fell 34 basis points from this year’s high of 4 percent on June 11.

Bernanke “helped to restore confidence in the market about exit strategies,” said Brian Weinstein, who runs the $9 billion TIPS fund in New York at BlackRock Inc., the largest publicly traded U.S. money manager. “The risk of inflation is longer term.”

Most Since 1950

While the economy is showing “tentative signs of stabilization,” the central bank intends to maintain a “highly accommodative” monetary policy for “an extended period,” Bernanke said in semi-annual testimony before the House Financial Services Committee.

Consumer prices have stabilized, after surging in the year earlier period on rising food and energy costs, as demand cooled following the collapse of global credit markets. Crude oil declined 54 percent to $68.05 a barrel on the New York Mercantile Exchange on July 24, from the record high of $147.27 set on July 11, 2008. The 1.4 percent drop in consumer prices last month was the biggest since January 1950.

Ten-year notes handed investors a loss of 1.6 percent last July once consumer prices were taken into account.

Sales Doubled

The U.S. more than doubled bond and note offerings to $963 billion in the first half of 2009 in an effort to end the recession and finance a budget deficit that the Congressional Budget Office projects will reach $1.85 trillion this year. It may sell another $1.1 trillion in the second half, according to London-based Barclays Plc, another primary dealer.

Including bills, the Treasury has raised $1.046 trillion in new cash this year, according to government data.

“There’ve been very valid concerns about whether the market would be able to take down that kind of supply consistently,” said Christopher Sullivan, who oversees $1.5 billion as chief investment officer at United Nations Federal Credit Union in New York. “Given the demand seen at many of the auctions, that fear has been a little bit misplaced.”

At the six sales of two-year notes this year, investors offered an average $2.81 of every $1 of debt sold, compared with $2.34 during the same period last year. For five-year notes, the so-called bid-to-cover ratio has risen to $2.22 in six sales, up from $2.07 last year.

New Cash

This week’s auctions will raise a record $96 billion in new cash, up from the previous record of $85 billion during the week of June 22, according to Louis Crandall, chief economist at Wrightson ICAP LLC, a Jersey City, New Jersey-based research firm that specializes in government finance.

Treasuries rallied that week by the most since the period ended March 20, as the yield on the 10-year note tumbled 24.5 basis points to 3.54 percent.

Citigroup expects that demand to continue as sales in other parts of the bond market decline. While the firm forecasts Treasury supply in fiscal 2010 to be $389 billion higher each quarter than the average from 2003 through 2008, it also sees sales from issuers such as government agencies and companies to be $326 billion lower per quarter.

International Demand

Demand from international investors has increased along with the sales. The government relies on foreign buyers to finance the budget deficit and almost 50 percent of the $6.6 trillion in marketable Treasuries are held outside the country, up from 35 percent in 2000, U.S. figures show.

Indirect bidders, a class of investors that includes central banks, purchased 67.2 percent of the record $27 billion in seven-year notes sold on June 25, or double the amount of bids at the last sale in May, according to the Treasury.

The ratio was the highest since 2004 on the sale of $37 billion in five-year notes the day before, while the $40 billion in two-year notes auctioned on June 23 attracted the highest percentage of indirect bids for that maturity in at least six years.

“U.S. short-term to middle-term securities are attractive because the market is pricing in a rate hike,” said Masataka Horii, one of four managers for the $47 billion Kokusai Global Sovereign Open fund in Tokyo. “But I think the U.S. will keep its zero-rate policy.”

International buyers increased their Treasury holdings by 7 percent through May to $3.29 trillion, while China, the biggest lender to the U.S., raised its holdings to $801.5 billion.

Bond Market Positive

Two-year notes are the only U.S. coupon securities to earn money for investors this year because of speculation the Fed won’t raise its target rate for overnight loans between banks from a range of zero to 0.25 percent.

The notes have returned 0.33 percent, including reinvested interest, according to Merrill Lynch indexes. Five-year notes lost 2.86 percent and 10-year securities are down 9.92 percent.

“What Bernanke said is positive for the bond market,” said Michael Cheah, who manages $2 billion in bonds at SunAmerica Asset Management in Jersey City, New Jersey. “Demand should be good because bond investors should take away from Bernanke being very specific that the Federal Reserve is committed to keeping short-term interest rates low.”