5-year notes: Sweet spot of the bond market

With the added backing of Federal Reserve Chairman Ben S. Bernanke, five-year Treasury notes have become the best bet in the government-bond market.

Not only have the securities posted their biggest gains in six years, they also have returned more than longer- and shorter-term Treasuries for the first time since 2003, according to indexes compiled by Merrill Lynch & Co. Inc., of New York. The performance shows a growing conviction that rising consumer prices will keep the central bank from reducing interest rates this year.

"There's more bang for your buck in five-year notes," said Nasri Toutoungi, who oversees $23 billion at Hartford Investment Management Co., of Hartford, Conn. Inflation and a weaker economy have made them "the ideal part of the yield curve," he said.

Five-year notes have gained 2.2 percent this year, compared with 1.7 percent for two-year securities, which gain the most when the central bank cuts its target for overnight loans between banks. Ten-year debt, whose value gets eroded more by inflation, advanced 2 percent, according to Merrill Lynch.

Investors who expected the Federal Reserve to lower interest rates from 5.25 percent have been changing their expectations since Bernanke told Congress on March 28 that "our policy is still oriented toward control of inflation, which we consider to be at this time to be the greater risk."

Before Bernanke's statement, options on Fed Funds futures showed an 84 percent chance of lower interest rates by September. Now, the odds are only 25 percent, options show.

The yield on the benchmark five-year note maturing in April 2012 was little changed yesterday at 4.56 percent. The price, which moves inversely to the yield, fell 1/32, or 31 cents per $1,000 face amount, to 99 24/32.

"Until the Fed actually starts to ease, you're going to see the five-year outperform," said T.J. Marta, a New York-based fixed-income strategist at RBC Capital Markets Corp., the investment-banking arm of Canada's largest bank.

The Fed's preferred measure of inflation, the Commerce Department's price index for consumer spending on items excluding food and energy, rose 2.1 percent in March from a year earlier, higher than the Fed's comfort level of 1 percent to 2 percent. April figures will be released June 1.

Producer prices excluding food and energy likely increased 0.2 percent last month, according to the median forecast of 44 analysts surveyed by Bloomberg News for a report to be released Friday. Analysts estimate that a report next week will show so-called core consumer prices increased to 0.2 percent from 0.1 percent.

Economists at some of the biggest investment banks say Bernanke is wrong. The Goldman Sachs Group Inc. economist Jan Hatzius, along with David Rosenberg of Merrill Lynch and Maury Harris of UBS AG, forecast at least three interest-rate cuts this year. They say the slump in housing will push the economy into a recession. Goldman and Merrill are based in New York. Harris works at UBS's U.S. securities unit in New York.

A National Association of Realtors index of pending sales of existing homes unexpectedly fell to the lowest level in four years in March.