Treasuries Decline Before Fed Minutes That May Stress Inflation

May 21 (Bloomberg) -- Treasuries fell, snapping a two-day gain, before the release of minutes of the Federal Reserve's last meeting, which may show it is done cutting interest rates on concern inflation may accelerate.

The 10-year note yield rose from the lowest level in more than a week as oil at a record prompted speculation U.S. price growth will quicken, eroding bonds' fixed payments. The difference between yields on 10-year Treasury Inflation Protected Securities and conventional notes of the same maturity was near the widest in more than two months.

``We've already had the Fed indicating they're not willing to drop rates further and that's keeping the market in a precarious position,'' said Marius Daheim, a senior bond strategist in Munich at Bayerische Landesbank, Germany's second- biggest state-owned bank. The minutes may show ``the Fed's starting to get worried about inflation expectations getting out of control.''

The U.S. 10-year yield climbed 1 basis point to 3.79 percent as of 6:56 a.m. in New York, after dropping to as low as 3.76 percent, according to bond broker BGCantor Market Data. The 3 7/8 percent security due May 2018 declined 3/32, or 94 U.S. cents per $1,000 face amount, to 100 23/32. The 10-year note yield may hold around 3.8 percent for the rest of the quarter, Daheim predicted.

Two-year yields rose 1 basis point to 2.33 percent. A basis point is 0.01 percentage point.

Business Confidence

Treasuries pared a decline as stocks in Europe faltered, while the cost of protecting the region's corporate bonds from default fell. European bonds dropped as German business confidence unexpectedly increased, reducing the likelihood the region's central bank will lower borrowing costs.

U.S. government notes have returned 2.7 percent so far this year, according to a Treasury master index compiled by Merrill Lynch & Co. That's more than similar-maturity European debt, which has earned 1.7 percent, the company's German Federal Governments index showed.

Europe's Stoxx 600 added as much as 0.3 percent and futures on the Standard & Poor's 500 Index expiring in June increased as much as 0.3 percent.

Banks are becoming more confident about lending after the Fed eased access to funding. The difference between three-month bill yields and the three-month London interbank offered rate, the so-called TED spread, narrowed to 77 basis points from this year's high of 2.03 percentage points on March 19. The spread averaged 39 basis points in the seven months through July last year, before the global credit squeeze began.

Futures Bets

Futures on the Chicago Board of Trade show there's an 88 percent chance the Fed will keep the target rate for overnight lending between banks at 2 percent on June 25. The odds of an increase to 2.25 percent by the end of the year are 57 percent.

``Monetary policy appears to be appropriately calibrated for now to promote both rising employment and moderating inflation over the medium term,'' Fed Vice Chairman Donald Kohn said yesterday in New Orleans. The economy should gradually strengthen as the interest-rate reductions take effect, he said.

The Fed will release the minutes of its April 30 meeting at 2 p.m. in Washington. Fed Governor Kevin Warsh is due to speak on the benchmark federal funds rate at 1 p.m. in Washington.

``We are going to see some movement out of Treasuries,'' said Robert Sinche, head of global currency strategy at Bank of America Corp. ``We favor inflation-protected securities,'' he said yesterday in an interview in San Francisco.

Inflation Expectations

The difference between yields on 10-year TIPS and 10-year notes was 2.5 percent today, near the highest since March 13. The gap, which represents the rate of inflation that investors expect for the next decade, has widened from 2.28 percentage points on April 30 when the Fed last met.

``The Federal Reserve will start raising rates at the end of this year and into next year,'' Markus Schomer, New York-based global economic strategist at AIG Global Investment Group, said in a Bloomberg Television interview in Hong Kong.

Declines by Treasuries may be limited as some investors bet the financial-market crisis isn't over and that the Fed may still cut interest rates this year. They rose in Asian trading with Japanese bonds as stocks declined. Japan's 10-year bond yield fell 3 basis points to 1.615 percent.

``It's a bit misguided to think the pause will continue for a considerable time and that the next move will be up not down,'' Andre de Silva, global deputy head of fixed-income strategy in London at HSBC Holdings Plc, said in a Bloomberg Television interview. ``The scope is still for further weakness in the U.S. We still think a cut is coming by the end of the year.''

Concern that credit losses will swell increased after American International Group Inc., the world's largest insurer by assets, said yesterday it will raise a total of $20 billion, 60 percent more than the New York-based insurer originally said it needed to protect against further writedowns.