(Bloomberg) -- As the Federal Reserve winds down its third round of unprecedented stimulus, one thing has become increasingly clear in the bond market:the U.S. economy just isnt going to grow enough to upend demand for Treasuries.
While more than $3 trillion of debt purchases since 2008 have helped the U.S. recover from its worst recession in seven decades, bond-market indicators for long-term inflation, growth and funding costs are all lower now than they were at the end of the central banks first two rounds of quantitative easing.
Investors diminished outlook for the economy could help prevent an exodus from the $12.2 trillion market for Treasuries and contain long-term borrowing costs for the government, companies and consumers as the Fed moves toward raising interest rates. After demand for the benchmark 10-year note this year pushed down yields by almost half-percentage point to 2.61%, implied yields now suggest investors dont foresee them increasing to 3% for at least another year.
Investors putting money to work are much more pessimistic, not just about the state of the U.S. economy but how well it can sustain a rate hike, Aaron Kohli, a New York- based interest-rate strategist at BNP Paribas SA, said in a telephone interview on Sept. 11. What the Fed may see as we get closer to a rate hike is the economic strength they thought was there is more of a mirage.
Kohli, whose firm is one of the 22 primary dealers that trade directly with the Fed, recommends buying 30-year U.S. bonds and selling those due in two years to three years.
The debate over the Feds interest-rate policy and its effect on bonds has intensified with the bank poised to end its third round of debt purchases known as QE3 next month.
The central bank, which reduced its monthly purchases to $25 billion in August from $35 billion in July, has bought so many bonds that its assets have ballooned to $4.42 trillion from less than $1 trillion in 2008.
Fed policy makers, who gather for a two-day meeting tomorrow, are already reassessing their own views on how long its target rate needs to stay close to zero as the U.S. recovery enters its sixth year. They are now considering whether to alter the guidance theyve had since March saying its rate would stay low for a considerable time after it stops buying bonds.
Philadelphia Fed President Charles Plosser, who dissented at the Feds last meeting in July, said Sept. 6 that keeping rates so low is a risky strategy.
Speculation the Feds policy statement this week will indicate officials are closer to lifting rates pushed up yields on the 10-year note by 0.15 percentage point last week, the biggest jump since August 2013.
Getting it right has never been more important for the Fed. With trillions of dollars of debt such as home loans and corporate bonds tied to Treasuries, any jump in borrowing costs threatens to stifle an economy thats failed to generate more than 3% growth in any year since the recession ended.
Even after six years of monetary stimulus, the bond market is signaling the economys potential to produce the kind of growth that compels Fed Chair Janet Yellen to aggressively lift rates and curb demand for fixed-income assets has lessened.
Bond traders now see consumer prices increasing an average 2.34% annually over the five years starting 2019, based on the five-year, five-year forward break-even rate, a metric the Fed uses to gauge long-term inflation expectations.
The level is within 0.01 percentage point of a three-year low and is also lower than at the end of both QE2 in June 2011 and the Feds first QE in March 2010, when inflation expectations in the bond market were above 3%.
Actual inflation using the Feds preferred measure has remained below its 2% target for 27 consecutive months.
I dont sense that people believe strongly enough to trade on it that Fed policy, by itself, can print money and bring inflation, Jim Vogel, the Memphis, Tennessee-based interest-rate strategist at FTN Financial, said on Sept. 8.
One of the biggest reasons bond investors are skeptical consumer price increases will accelerate is because sustained wage growth among U.S. workers remains elusive.
On an annual basis, growth in hourly earnings in the past five years has been the weakest over the course of any expansion since at least the 1960s, data compiled by Bloomberg show. Employers added just 142,000 jobs last month, the fewest this year, halting a six-month streak of employment gains surpassing 200,000 that was the most since 1997.
The lack of earnings growth may hamper consumer spending, which accounts for 70% of the economy, and also constrain future growth. The narrowing gap between short- and long-term yields suggests the bond market supports that view.
The difference between five- and 30-year Treasuries, which usually widens as growth prospects improve, was at 1.52 percentage points as of 8:26 a.m. New York time. Thats at least 0.4 percentage point less than at the end the two prior rounds of QE. Since the start of QE3, the gap has fallen 0.85 percentage point.
Donald Ellenberger, who oversees about $10 billion as the head of multi-sector strategies at Federated Investors, says bond investors are missing the signs that support forecasts for the fastest U.S. economic growth in a decade next year.
Sales at retailers climbed 0.6% in August, the quickest pace in four months, while manufacturing rose to a more than three-year high. At the same time, banks boosted the amount of business loans to a record $1.75 trillion last month.
The rally in the Standard & Poors 500 Index of American equities to an all-time high is also a sign the U.S. economy is strengthening, according to Ellenberger.
Judging the economy depends on what indicators youre looking at, Ellenberger, who holds a smaller proportion of Treasuries than allocated in benchmarks, said by telephone from Pittsburgh. The fundamentals to support it are improving.
Options traders are also stepping up wagers that stronger growth will lead the Fed to raise interest rates more than they previously priced in.
Bearish options that expire in coming months on Eurodollar futures due in December 2017 now exceed bullish contracts by 3- to-1, double the ratio eight weeks ago, data compiled by CME Group Inc. show. That implies traders are more confident than they were in the past that rates will rise to higher levels.
Even after 10-year Treasuries suffered their longest losing streak of the year, traders are confident that yields will remain below levels demanded in previous periods of growth.
Implied yields on 10-year Treasuries suggest that they wont reach 3% until October next year. Thats at least 0.7 percentage point less than at the end of the two prior QE cycles. Ten-year yields averaged more than 4% over the course of the last two expansions.
Treasuries have rallied this year, confounding forecasters who predicted yields would rise as the economy strengthened.
While the prognosticators have pointed to everything from the harsh winter to turmoil in Russia and the Middle East for why Treasuries remain in demand, lower potential growth of the U.S. economy may be a better reason, according John Bellows, the Pasadena, California-based money manager at Western Asset Management, which oversees $75 billion of fixed income.
You never quite get back the growth youve lost from the credit crisis, he said in a Sept. 11 interview at Bloomberg headquarters in New York. You do lose some potential.
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