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Bond yields are going to surge! Eventually?
May 2nd, 2012 2:41 PM


NEW YORK (CNNMoney) -- Yields on benchmark 10-year U.S. Treasury bonds are back below 2%. They really shouldn't be this low. Most fixed income investors agree that's the case. Yet, people keep clinging to long-term securities like Linus Van Pelt does to his baby blue security blanket.

Cue the Vince Guaraldi soundtrack, and welcome to the bizarre world of bonds -- where bad economic news from America only makes Treasuries look even safer!

Even though the latest ADP job figures for April point to a potentially disappointing payrolls number from the government Friday, investors still take solace in the fact that the U.S. isn't Europe.

The yield on the 10-year Treasury dipped as low as 1.9% on Wednesday morning. That's not too far above the low for 2012 of about 1.8%. It's not even out of the realm of possibility that yields could soon test last September's all-time low of 1.68%.

Since bond rates fall when prices rise, many investors apparently still find something attractive about Treasuries. And it can't be those puny yields.

"Clearly, the push into bonds is coming from exogenous factors. And it's primarily concerns about Europe," said Pat McCluskey, senior fixed income strategist with Wells Fargo Advisors in St. Louis.

McCluskey argues that if not for the debt crisis in Europe, the 10-year Treasury would probably be yielding something closer to 3% than 2%. But as long as investors remain worried about the growing list of eurozone nations falling into double-dip recession and unemployment that remains in the double digits, the U.S. still looks relatively healthy by comparison.

Sure, there's a lot to hate about the U.S. economic situation right now. The latest jobs numbers, most notably the much weaker jobs gains in March, are a step in the wrong direction. The housing market is still a mess.

And unless the nitwits in Washington take a break from campaigning to actually do some real work on Capitol Hill, there is a huge risk of the U.S. falling off a fiscal debt cliff shortly after the election.

Nonetheless, the U.S. is still the best of a sorry lot among the key developed markets. Treasury bonds may be the equivalent of a Ford Pinto or AMC Gremlin. But Europe's debt is a Yugo.

Stephen Hammers, chief investment officer of Compass EMP Funds in Brentwood, Tenn., said he thinks Treasuries look like good short-term bets right now because nervous investors are fleeing European stocks and bonds in favor of dollar-denominated assets.

Hammers said there are two compelling reasons for U.S. bond yields to spike higher in the near-term: strong economic improvement or more concerns about the federal budget deficit further getting out of hand.

The former doesn't seem likely. But the latter is a possibility as we approach the end of the year.

After all, the reason that bond rates are so high in places like Italy, Spain and Greece isn't because of overheating economies and runaway inflation. It's due to a lack of confidence in those nations' abilities to get their debt under control.

With that in mind, experts say U.S. bond rates should eventually spike higher. But it's going to be difficult to pinpoint when that will take place and how high that will go .. especially since the Federal Reserve is still buying bonds.

The central bank is currently in the process of completing what's known as Operation Twist, swapping short-term bonds on its balance sheet for longer-term securities. Twist is set to expire in June and is unlikely to be extended.

Prior to Twist, the Fed propped up the financial markets with two rounds of quantitative easing, programs where the Fed has bought up long-term debt to try and keep rates low. So with each new negative data point about the economy, there is likely to be more cries for a third dose of quantitative easing, or QE3.

Those calls may fall on deaf ears. Many experts think the Fed won't act that aggressively unless there is more concrete data of a major slowdown. A couple of months of payroll gains below 200,000 is not great news. But it's not a reason to panic either, especially if more Fed stimulus creates inflation pressure.

"A sudden spike higher in yields would be something the Fed would want to fight. But bond yields are still low and following the path of the data," said Rob Robis, head of fixed income macro strategies at ING Investment Management in Atlanta. "There is no reason for the Fed to act just yet."

If the Fed doesn't hint at more easing anytime soon, that could spook the market and cause rates to shoot higher. Many investors may be looking for the merest excuse to finally unload bonds.

"Treasuries are richly priced right now," Robis said. "And if the market starts to wonder who will be buying bonds that the Fed won't be buying, that could put upward pressure on yields."

McCluskey agreed. He noted that the Fed can't adopt a policy of permanent QE. And sooner or later, investors from China, Japan and other countries that hold a lot of U.S. debt could tire of owning assets that yield relatively nothing.

"The combination of Fed policy and foreign demand for bonds has kept rates low for a while. You can't count on that forever," he said.

But Hammers said the key for investors is timing, getting out before sentiment starts to shift. For now though, the market still has faith in the United States. So the bond bubble that many think has to pop at some point could wind up getting a little bit bigger before it finally bursts.

"Eventually, people will feel sorry for bond investors. But for now, Treasuries and the dollar are still considered safe," Hammers said.


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Posted by Narbik Karamian on May 2nd, 2012 2:41 PMPost a Comment

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