June 25 (Bloomberg) -- Treasuries fell on speculation the Federal Reserve may signal after its interest-rate decision today that inflation is a bigger risk to the U.S. economy than slowing growth.
The decline pushed 10-year yields up by the most in almost two weeks on expectations the central bank is preparing financial markets for a policy shift. Fed Chairman Ben S. Bernanke said on June 9 the risks of a ``substantial downturn'' in the economy have diminished and policy makers will ``strongly resist'' an increase in inflation expectations.
``You're getting a little lightening up ahead of the'' Fed meeting, said Michael Cloherty, an interest-rate strategist in New York at Banc of America Securities LLC, one of the 20 primary dealers that trade with the central bank. ``They're certainly going to have to sound more concerned about inflation.''
The yield on the 10-year note rose 8 basis points, or 0.08 percentage point, the most since June 12, to 4.16 percent at 11:49 a.m. in New York, according to BGCantor Market Data. The price of the 3.875 percent security due in May 2018 fell 19/32, or $5.94 per $1,000 face amount, to 97 23/32. The two-year note's yield rose 8 basis points to 2.92 percent.
Treasuries remained lower after the Commerce Department said new-home purchases fell to an annual rate of 512,000 in May, from 525,000 the previous month. That matched the median estimate of 73 economists in a Bloomberg survey.
The report ``may be a sign that housing is finding a bottom, and that's a great sign the Fed can start fighting inflation,'' said Michael Franzese, head of government bond trading at Standard Chartered in New York.
Fed Bets
Traders see a 90 percent chance the Fed will leave the target rate for overnight lending between banks at 2 percent today, futures contracts on the Chicago Board of Trade indicate, ending a run of seven cuts totaling 3.25 percentage points. The rest of the bets are for policy makers to raise the rate a quarter-percentage point. For the Fed's next meeting, in August, traders put 37 percent odds on an increase of at least a quarter-percentage point.
``There could be a pretty substantial sell-off in bonds at the front end if the Fed were to signal'' it plans to increase the rate at its next meeting, said Suvrat Prakash, an interest- rate strategist in New York at BNP Paribas Securities Corp., another primary dealer. ``They'd have to actually shift the balance of risks and say, `we now feel the balance of risks are skewed slightly to the upside on inflation.'''
Inflation Expectations
Inflation expectations are rising, according to the difference in yields between 10-year Treasury Inflation Protected Securities, or TIPS, and conventional notes. The so- called breakeven rate was at 2.49 percentage points today, up from this year's low of 2.20 percentage points on Jan. 22.
U.S. government debt is headed for its biggest quarterly loss in four years on speculation Fed officials plan to raise borrowing costs this year to curb inflation. Consumer prices rose 4.2 percent in the 12 months ended in May, the fastest pace since January.
Treasuries lost 2.9 percent so far this quarter, according to Merrill Lynch & Co.'s U.S. Treasury Master Index, the most since the second quarter of 2004. They've still returned 1.3 percent this year.
By contrast, German government debt has lost investors 2.5 percent and Japanese bonds 2 percent this quarter.
Treasuries declined as gains in equities eroded demand for the safest assets. U.S. stocks posted their biggest increase in two weeks, with the Standard & Poor's 500 Index rising about 1 percent.
Post-Fed Rally
The decline in government debt wasn't enough to erase yesterday's gains. Two-year Treasury note yields fell to the lowest level in three days yesterday after reports showed consumer confidence plunged to a 16-year low and housing prices dropped in April by 15.3 percent, the most on record.
Treasuries may rally after the Fed's scheduled policy announcement at 2:15 p.m. in Washington because officials will probably stop short of indicating they plan to raise borrowing costs, said Martin Mitchell, head government bond trader at the Baltimore unit of Stifel Nicolaus & Co.
``I don't think the Fed's in a position to do that to the economy,'' Mitchell said.
The central bank will lower borrowing costs to 1.5 percent by March to shore up the economy as inflation moderates, driving yields on U.S. notes lower, David Rosenberg the chief North American economist at Merrill Lynch & Co. in New York, wrote in a note to clients. The 10-year note's yield will peak at 4.3 percent in the third quarter and fall more than 1 percentage point by the middle of next year, he added.
TED Spread Widens
Credit risk as measured by the so-called TED spread increased to the highest level in six weeks on speculation losses and writedowns at banks that have swelled to almost $400 billion will slow global economic growth. The spread, measuring the difference between what banks and the U.S. government pay to borrow in dollars for three months, widened to 101 basis points today, the most since May 9.
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