By Liz Capo McCormick Dec. 14 (Bloomberg) -- Futures traders are reducing bets for gains in two-year Treasuries as Federal Reserve officials meet this week amid signs the economic recovery is lifting the labor market from its worst slump since before World War II. Hedge-fund managers and other large speculators cut so- called net-long positions in two-year note futures by 4.2 percent, the most in five weeks. The contracts dropped to 204,891 in the period ended Dec. 8 from the record high of 221,816 on Nov. 10, according to data compiled by the U.S. Commodity Futures Trading Commission in Washington. While all 91 economists in a survey by Bloomberg News said the Fed will keep its target interest rate for overnight loans between banks near zero, futures suggest investors expect the central bank late next year to start draining reserves pumped into the economy when credit markets seized up in 2007 and 2008. Prices of federal-funds futures contracts on the CME Group show a 53.6 percent chance policy makers will lift interest rates by midyear, up from 38.9 percent a month ago. “It is difficult to believe, even with the Fed’s zero interest rate policy, that people are going to continue to pile into two-year Treasury notes at yields of only about 0.7 percent,” said Michael Marzano, senior vice president of interest-rate futures trading at Prudential-Bache Commodities in Chicago. Rising Yields Two-year yields have risen to 0.79 percent from 0.67 percent at the end of November as the price of the benchmark 0.75 percent note due November 2011 declined. It was little changed today at 99 29/32 as of 10:47 a.m. in Tokyo according to BGCantor Market Data. The securities have lost 0.27 percent in December, making this month the worst since they fell 0.42 percent in May 2008, Merrill Lynch & Co. index data show. Fed policy makers will meet this week in Washington and keep the target rate at a range of zero to 0.25 percent, the survey shows. The Fed won’t increase borrowing costs until the third quarter of 2010, the economists estimate. “The economy has been turning for about a year now, evident in a plethora of data from jobless claims to retail sales to employment,” said Tony Crescenzi, a strategist and money manager at Newport Beach, California-based Pacific Investment Management Co., manager of the world’s largest bond fund. “The economy is improving.” Rate Bets Traders started moving up their timing of a likely rate boost after the Labor Department said Dec. 4 the economy lost 11,000 jobs last month, compared with the median estimate for a decrease of 125,000. Last week, government reports showed the four-week average of jobless claims declined to a one-year low of 473,750 from 481,500, and that retail sales excluding autos climbed 1.2 percent in November, the most since January. “The economy is showing clears signs of acceleration,” economists at New York-based JPMorgan Chase & Co. said in a report dated Dec. 11. They raised their fourth-quarter annualized GDP forecast to 4.5 percent growth from 3.5 percent. Net-long positions in two-year notes as measured by the CFTC have increased from a net-short position of 23,229 contracts in January. The securities have outperformed longer- term debt this year as the Fed kept rates unchanged and the Treasury sold more notes due in five years or more to lengthen average maturities and take advantage of some of the lowest yields on record. Profitable Investment Notes due in two years have returned 1.6 percent since the end of 2008, including reinvested interest, while 10-year notes have lost 7.2 percent, according to Bank of America Corp.’s Merrill Lynch Treasury index data. Investors are still attracted to the safety of fixed-income mutual funds, even as the Standard & Poor’s 500 Index surged 66 percent from a 12 1/2-year low in March. Investors added a net $297 billion to bond funds in the first 10 months of 2009, compared with $12 billion for stock funds, according to Morningstar Inc. “There is the notion out there that there are not a lot of good alternatives for where to put your money if you are not looking to take significant volatility risk,” said Ira Jersey, head of U.S. interest-rate strategy at Royal Bank of Canada in New York. “Ultimately, you are not going to see an abatement of this flight to quality trade for a long time. You still have institutions that are reasonably risk averse.” Fed officials pledged at their Nov. 4 meeting to keep rates near zero for “an extended period” and specified for the first time that policy will stay unchanged as long as inflation expectations are stable and unemployment fails to decline. ‘Very Vulnerable’ “The two-year Treasury note is very vulnerable to upside economic surprises,” said Michael Darda, chief economist at institutional trading and research firm MKM Partners in Greenwich, Connecticut. “The Fed probably does nothing until late 2010 at the earliest, even with a strong recovery. Still, the short-end of the Treasury curve should be avoided.” Darda predicts that economic growth may be as high as 4 percent in 2010. That compares with contraction of 2.50 percent this year based on the median estimate of 83 forecasts in a Bloomberg survey. Policy makers led by Fed Chairman Ben S. Bernanke are considering how to withdraw the more than $1 trillion they pumped into the financial system to combat the deepest recession since the 1930s. Along with raising the overnight bank lending rate, Fed officials have said they may use reverse repos, pay interest on excess bank reserves and sell securities directly to investors to withdraw or neutralize cash in the banking system. Reverse Repo The central bank began testing its so-called reverse repo procedures on Dec. 3, and has drained $990 million since then. In a reverse repo, the Fed lends securities for a set period. At maturity, the securities are returned to the Fed, and the cash to the 18 primary dealers that act as counterparties to the central bank. While the Fed said the moves don’t signal a change in policy, traders said it underscores the notion that the unprecedented easing is coming to an end. “Yields are at levels where some people think there is no reason for rates to go any lower,” said Thomas L. di Galoma, head of U.S. rates trading at Guggenheim Partners LLC, a New York-based brokerage for institutional investors. “The perception among most professionals is that interest rates are heading higher.” To contact the reporter on this story: Liz Capo McCormick in New York at Emccormick7@bloomberg.net.

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