U.S. Notes Fall as Pianalto Says Inflation `Uncomfortably High'

June 11 (Bloomberg) -- U.S. Treasuries fell, extending five weeks of losses, as Federal Reserve Bank of Cleveland President Sandra Pianalto said inflation is ``uncomfortably high.''

Fourteen of the 21 primary dealers that underwrite the government's debt boosted their year-end estimate for the central bank's target rate or the 10-year note's yield. This week the government will release reports on consumer and wholesale prices. Yields on 10-year notes exceed two-year securities by 14 basis points, the most since May 2006.

``A lot of people are throwing in the towel and the curve needs to steepen,'' said Richard Schlanger, who manages about $4 billion of fixed-income assets, including Treasuries, at Pioneer Asset Management in Boston.

The yield on the benchmark 10-year note rose 3 basis points, or 0.03 percentage point, to 5.14 percent at 11:34 a.m. in New York, according to bond broker Cantor Fitzgerald LP. The price of the 4 1/2 percent note due May 2017 fell 1/4, or $2.50 per $1,000 face amount, to 95 3/32. Yields move inversely to prices.

The two-year note yield was unchanged at 5 percent. Two-year note yields have been lower than 10-year Treasuries for four days as investors demand higher returns on long-term debt to compensate for the risk alternative investments will provide greater returns over time.

`Uncomfortably High'

The Fed ``has described our core rate of inflation as being uncomfortably high and has stressed the importance of further moderation in inflation,'' Pianalto said today at a conference in Dublin. The Fed's Open Market Committee is likely to keep its target rate for overnight loans between banks at 5.25 percent when it meets on June 28, according to the median forecast in a Bloomberg News survey of economists.

The Commerce Department's price gauge tied to spending patterns and excluding food and energy costs rose 2 percent from April 2006, according to data released June 1. The index hasn't been below 2 percent since March 2004.

Bill Gross, manager of the Pacific Investment Management Co.'s $103 billion Total Return Fund, the world's biggest bond fund, is sticking with his forecast for the Fed to lower interest rates in a ``schizophrenic'' market probably within six months or more.

Housing-Led Slowdown

The central bank will keep its target rate for overnight loans between banks at 5.25 percent until a housing-led slowdown will drop inflation below 2 percent, Gross said today in an interview in New York.

Producer prices excluding food and energy rose 0.2 percent in May after being flat during April, according to the median estimate of 69 economists in a Bloomberg survey.

Consumer prices excluding food and energy also rose 0.2 percent in May, the same as in April, according to the median forecast of 72 economists in a separate survey.

U.S. Treasuries underperformed their European peers. The extra yield that investors demand for holding the 10-year U.S. note over the equivalent maturity German bund rose to 57 basis points from 53 basis points on June 8.

``The market is fearful that not only is the Fed not going to cut rates, but that it may have to raise rates,'' said Nick Stamenkovic, a strategist at RIA Capital Markets Ltd. in Edinburgh. ``The Treasury yield has further to rise. I think at least it will be 5.25 percent, if not 5.50, for the 10-year note before we see investors buying again.''

Options prices on fed funds futures on June 8 showed about 44 percent of investors are betting the Fed's benchmark rate will rise to 5.5 percent and 39 percent wagering on at least one cut by year-end. On May 1, they showed no expectations for an increase.

Volatility Gauge

Merrill Lynch & Co.'s MOVE Index, a volatility gauge based on prices of over-the-counter options on Treasuries maturing in two to 30 years, rose to 79.10 June 8, the highest since November 2005, as Treasury yields posted their biggest weekly increase since June 2006.

``We had volatility so low for a long time as the market became complacent about the Fed,'' said Theodore Ake, head of U.S. Treasury trading at primary dealer Mizuho Securities USA Inc. in New York. ``With global rates moving up and the Fed ease off the table, and a possible tightening, volatility will remain raised.''

Fed policy makers kept the overnight lending rate between banks at 5.25 percent at their last seven meetings.

`Good Buying Opportunity'

``The current levels actually present a good buying opportunity,'' said Dariusz Kowalczyk, chief investment officer at CFC Seymour Ltd. in Hong Kong. ``I don't think that the gains, especially at the long end of the curve, have been justified fundamentally, so in the medium term it's probably a very attractive level to jump back into the market.''

Fund managers who oversee $1.34 trillion said Treasury and agency securities fell to 26 percent of their holdings from 36 percent as of May 18, according to a survey by Ried Thunberg & Co., a Jersey City, New Jersey-based research firm.

``Ten-year yields at 5.25 percent would be too high,'' said Shun Totani, who helps manage about $600 million of non-Japanese bonds at Asahi Life Asset Management Co. in Tokyo. He bought 10- year Treasuries on June 8 and may add to his holdings should yields rise above 5.15 percent again.