By Daniel Kruger and Cordell Eddings May 17 (Bloomberg) -- Europe’s sovereign debt crisis is prompting some of the Treasury market’s biggest bears to reverse calls for Federal Reserve interest-rate increases this year. Morgan Stanley, Wrightson ICAP and Pierpont Securities LLC say the Fed will keep interest rates near zero percent after the European Union unveiled an almost $1 trillion loan package to halt a slide in the euro and local bonds that threatened to shatter the currency union. Futures show traders place a 40 percent likelihood that the central bank will raise borrowing costs by December, down from 73 percent a month ago. “This is a mea culpa from me on our rate call,” James Caron, global head of interest-rate strategy at Morgan Stanley, wrote at the start of a May 13 report. The New York-based firm, the most pessimistic among the Fed’s 18 primary dealers, reduced its year-end 10-year note yield forecast to 4.5 percent from 5.5 percent. “We did not appropriately discount the sovereign risk conditions which have contributed to keeping yields low.” Firms that started 2010 predicting a second consecutive year of losses in U.S. government debt are growing less pessimistic after the Fed opened currency swap lines last week to central banks to ensure European financial institutions have access to dollars, expanding the Fed’s balance sheet. Treasuries, the benchmark for everything from corporate bonds to mortgage rates, have returned 3.4 percent since December, including reinvested interest, the most at this point in a year since gaining 8.48 percent in 1995, according to Bank of America Merrill Lynch indexes. ‘Intense Focus’ While policy makers are putting plans in place to reduce reserves as a step toward bringing borrowing costs back into line after cutting the target for overnight loans between banks during the 2008 credit crunch, the swap lines put those efforts on hold, said Lou Crandall, the chief economist at Wrightson, a Jersey City, New Jersey-based unit of ICAP Plc that specializes in U.S. government finance research. The Fed’s balance sheet increased by $10 billion to almost a record $2.34 trillion in the week ended May 12 as seven firms took advantage of the swap lines to arrange dollar loans through the European Central Bank. That’s up from less than $2 trillion as recently as August. ‘Intense Focus’ “The fact that they felt they need to do this reflects the attitude that they’re not anywhere near considering a rate hike,” Crandall said in an interview on May 11. It shows “their intense focus on rebuilding a damaged global financial system,” he said. Wrightson pushed back its forecast for a Fed increase to the first half of 2011 from November. Policy makers have kept their target rate in a range of zero to 0.25 percent since December 2008. The yield on the two-year Treasury fell two basis points to 0.76 percent as of 11:35 a.m. in Tokyo. It declined to 0.66 percent on May 6, the lowest since Dec. 2. The 1 percent note due April 2012 rose 1/32, or 31 cents per $1,000 face amount, to 100 14/32, according to data compiled by Bloomberg. Ten-year yields dropped five basis points to 3.41 percent. The median estimate of 72 economists surveyed by Bloomberg News from April 29 to May 10 is for the federal funds rate to rise to 0.5 percent by year-end. That’s down from 0.75 percent in the previous monthly poll. Fed Bank of Chicago President Charles Evans said “very accommodative” rates are appropriate, though they will have to rise over time. The Fed said last month the labor market was improving and household spending has picked up as it reiterated rates will stay near zero for an “extended period.” ‘More Uncertain’ “The risks, obviously, with the global situation make things a little bit more uncertain than we were expecting,” Evans told reporters May 14. “If anything, I’m even more comfortable with my assessment that accommodation continues to be appropriate.” Forecasters have been reluctant to lower their yield forecasts because of the improving economy. The two-year note yield may rise to 1.70 percent this year, according to the median estimate of 63 strategists and economists surveyed by Bloomberg. That would result in a loss of about 0.71 percent. The sovereign crisis sweeping Europe is unlikely to produce the fallout like the seizure in credit markets did, according to Michael Darda, the chief economist at MKM Partners LP in Greenwich, Connecticut. “It is probably going to be a mistake for investors to interpret this as a replay of 2007-2008,” Darda said. “Ultimately this is going to prove to be temporary. I don’t think this is a turning point.” Rates and Growth Analysts are paring interest-rate forecasts even as the economy accelerates. After contracting 2.4 percent in 2009, the U.S. will expand 3.2 percent this year and 3 percent in 2010, the median forecasts of 90 economists in a Bloomberg News survey. The reduction of forecasts is a function of the turmoil in Europe and concern financial institutions there will suffer losses. The euro zone economy is forecast to grow 1.05 percent this year and 1.45 percent in 2011, another survey shows. Demand for dollars and U.S. assets is increasing, as is typical in times of stress, such as after Lehman Brothers Holdings Inc.’s collapse in September 2008. Foreign bank borrowing of dollars from their U.S. offices climbed almost 50 percent to $353.3 billion in the three months ended May 5, Fed data tracked by Nomura Holdings Inc. shows. The jump is the largest quarterly percentage rise since 2007. Basis Swaps The rate on one-year cross-currency basis swaps between euros and dollars reached minus 58.75 basis points this month, the largest effective premium for dollar borrowing since February 2009. Basis swaps allow investors to borrow in one currency and simultaneously lend in another. While the EU shares a common monetary policy, members are responsible for their own fiscal decisions. That allowed Greece’s budget deficit to expand to almost 14 percent of its gross domestic product, exceeding the EU’s 3 percent limit without penalty. Germany’s is 3.2 percent of its GDP. “The issue with this big bailout package is it probably stabilizes things in the short run but doesn’t address the root causes of the problem,” said Stephen Stanley, chief economist at Pierpont Securities in Stamford, Connecticut. “These countries are going to have to get their fiscal houses in order, and if they don’t, given the mechanisms that have been put into place, it creates an unsustainable situation.” Stanley, the former chief economist at primary dealer RBS Securities, expects rates to remain unchanged this year, down from an earlier forecast for an increase to 1.5 percent. Fed Counterweight By implementing the currency swaps, Fed Chairman Ben S. Bernanke is positioning the Fed as a counterweight to the austerity plans in Europe that threaten the recovery in the U.S., Crandall said. Greek Prime Minister George Papandreou has said he would cap wages for some state workers and impose a partial hiring freeze in a first round of measures to reduce the nation’s deficit. On May 12, Spain’s Prime Minister, Jose Luis Rodriguez Zapatero announced the biggest round of budget reductions in 30 years including a 5 percent cut in public wages. In Portugal, Finance Minister Fernando Teixeira dos Santos says he’s prepared for “social tension” after announcing additional cuts. “The prospect that fiscal policies around the world are going to be tightening sooner than thought because the bond vigilantes finally started riding is a reason to think the monetary policy will be slower to adjust,” Crandall said. If not for Europe’s sovereign debt crisis, Richard Schlanger would be selling Treasuries, instead of buying. Not Convinced “Based on domestic fundamentals you have to say that Treasuries are overbought,” said Schlanger, who helps invest $18 billion in fixed-income securities as vice president at Pioneer Investments in Boston. He added to his U.S. government debt holdings even though “things are improving domestically” because the threat to the U.S. economy and global financial markets makes holding safe assets necessary, he said. “They can stick their fingers in the dykes and it may prevent the initial leakage, but I’m not completely convinced that this is a panacea,” Schlanger said. “There going to be broader implications: slower growth, less inflation.” To contact the reporters on this story: Daniel Kruger in New York at dkruger1@bloomberg.net; Cordell Eddings in New York at ceddings@bloomberg.net.

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