Money Rates Rising Signals Treasury Losses as Fed Prepares Exit

March 15 (Bloomberg) -- Money market interest rates at five-month highs show the Federal Reserve is laying the groundwork to siphon a record $1 trillion in excess cash from the banking system and sending a bearish signal on Treasuries.

Overnight federal funds rates rose to the highest since September and the cost to dealers to borrow and lend U.S. securities for one day more than doubled in the past month. Three-month Treasury bill rates rose last week to the highest since August.

The rise is a sign traders are preparing for tighter monetary policy as stimulus measures end. In the three months before the Fed started raising borrowing costs in June 2004, 10- year Treasury yields rose about 0.75 percentage point as bond prices fell. While higher rates mean increased borrowing costs for President Barack Obama, they also show growing confidence that the economic recovery is gaining traction.

“The Fed is definitely getting its ducks in a row,” said Mark MacQueen, a partner at Austin, Texas-based Sage Advisory Services Ltd., which oversees $7.5 billion. “There is no doubt that in the early phases of the Fed’s plan, the Treasury market could suffer.”

A surprise first-quarter rally in Treasuries is already losing momentum. Bonds have lost 0.52 percent in March after gaining 0.4 percent last month and 1.58 percent in January, according to Bank of America Merrill Lynch index data. Bond dealers said at the end of 2009 that government bonds would fall again this year.

Sales Surge

Fresh evidence of the recovery came March 12, when the Commerce Department said retail sales climbed 0.3 percent in February, the fourth gain in five months. Purchases were projected to fall 0.2 percent, according to the median estimate of 77 economists in a Bloomberg survey. Sales excluding autos rose 0.8 percent, exceeding the estimates of all 68 economists surveyed.

Morgan Stanley economists said in a report last week they expect the U.S. economy to expand 3.2 percent this year, up from their forecast in December of 2.8 percent.

Fed Chairman Ben S. Bernanke and his fellow policy makers will likely keep their target rate for overnight loans between banks in a range of zero to 0.25 percent at a meeting tomorrow, according to Bloomberg News surveys. Even so, some central bankers say the Fed should end its pledge to keep rates close to zero for an “extended period” as the economy recovers.

Fed Dissension

Kansas City Fed President Thomas Hoenig voted against repeating the statement on Jan. 27 because he wanted to keep “the broadest options possible.” Since then, Dallas Fed President Richard Fisher, James Bullard of St. Louis and the Philadelphia Fed’s Charles Plosser have also expressed reservations.

Policy makers have kept the target rate for overnight loans unchanged since December 2008, and pumped more than $1 trillion in excess cash into the banking system to unlock credit markets after banks and financial companies reported about $1.8 trillion in writedowns and losses.

The effective fed funds rate, or volume-weighted average of rates dealers charge each other that’s published daily by the New York Fed, has moved closer to the top of the central bank’s band. Funds reached 0.17 percent on March 5, the highest since Sept. 16.

‘Clearly Afoot’

“Something is clearly afoot, and while the move may not be imminent, the direction is clearly not in doubt,” said Chris Ahrens, head of interest-rate strategy in Stamford, Connecticut at UBS AG. The firm is one of the 18 primary dealers that act as counterparties on the Fed’s open market operations.

An influx of government securities after the Treasury expanded its Supplementary Financing Program, where it sells bills on the central bank’s behalf, to $200 billion from $5 billion in February has lifted repurchase agreement, or repo, rates. The program is part of the central bank’s strategy for rolling back its assistance to financial markets.

The average level of overnight general collateral repo rates traded on March 5 through London-based ICAP Plc, the world’s largest inter-dealer broker, touched 0.19 percent, the highest since December. It was 0.07 percent last month.

Securities dealers use repos to finance holdings and increase leverage. Government securities that can be borrowed at rates close to the Fed’s target for overnight loans between banks are called general collateral.

Moving Closer

The Fed moved closer to withdrawing stimulus when it said last week it plans to use money market funds in addition to primary dealers to drain excess reserves before the record amount of cash in the financial system leads to inflation.

“We’re now getting closer to the point here where we see further removal of monetary stimulus,” said Derrick Wulf, a money manager at Burlington, Vermont-based Dwight Asset Management Co., which oversees $69 billion. “Some very subtle steps have already been taken.”

Yields on 2-year notes rose 6 basis points, or 0.06 percentage point, to 0.96 percent last week, up from the low this year of 0.72 percent on Feb. 5. Rates on three-month bills rose as high as 0.155 percent, from this year’s low of 0.2 percent on Jan. 11.

Treasuries rallied in January as Greece’s budget crisis fueled demand for the safety of U.S. government debt and helped the securities beat predictions for losses.

Financing Costs

Higher yields means increased government financing costs as the Obama administration borrows record amounts to sustain the recovery. U.S. marketable debt has risen to an unprecedented $7.41 trillion to fund a budget deficit the government predicts will swell to $1.6 trillion in the fiscal year ending Sept. 30.

The Treasury will sell a record $2.55 trillion of notes and bonds this year, an increase of about $440 billion, or 21 percent, from last year, Morgan Stanley estimated at the end of 2009. The New York-based firm is also a primary dealer.

Treasury 2-year note yields will climb to 1.91 percent and 10-year note will yield 4.19 percent at the end of the year, according to Bloomberg surveys. David Greenlaw, the chief fixed- income economist at Morgan Stanley, has the most bearish forecast, predicting 10-year yields will touch 5.5 percent amid increased supply and as the Fed ends its housing debt purchase program.

Tighter credit spreads, a 29 percent gain in company debt since the end of 2008 and a 27 percent rally in the Standard & Poor’s 500 stock index in the same period suggest Treasuries face more competition for funds and less investor demand for a refuge from risk.

Fed Futures

“We expect the supply/demand imbalance to intensify,” Anshul Pradhan, a fixed-income research analyst at Barclays Plc in New York, wrote in a report dated March 12. The firm, also a primary dealer, predicts 10-year yields will rise to 4.3 percent by year-end.

Futures contracts on the Chicago Mercantile Exchange show a 45.6 percent probability the Fed will raise rates by September. The median estimate of 51 economist surveyed by Bloomberg News is for an increase to 0.75 percent by year-end.

Volatility in Treasuries may rise from the lowest level since before the credit markets seized up as the Fed moves closer to shifting monetary policy, according to Ira Jersey, the head of interest rate strategy in New York at primary dealer Royal Bank of Scotland Group Plc. Bigger price swings may cause traders to demand higher yields to compensate for the fluctuations.

Merrill Lynch’s MOVE Index, an options-based gauge of expectations for price swings in Treasuries, fell this month to the lowest since July 2007. A Barclays index of volatility in options on interest-rate swaps, used to hedge the affects of rate swings, fell last week to a 10-month low of 97.28 basis points.

“Interest rate volatility, which has gotten crushed this year, is likely to head higher,” said Jersey. “This will be in part from investors misinterpreting the Fed’s actions in the months ahead. As the Fed begins to drain reserves, there will be false starts that trigger increases in yields.”