Inflation Jitters Send Bond Yields Up Again

Long-term bond yields rose to fresh two-year highs on Monday, underscoring how nervous investors have become about the outlook for inflation and for Federal Reserve policy.

But with the latest uptick in yields, some analysts wonder if the market may be approaching at least a near-term rate peak.

The yield on the benchmark 30-year Treasury bond soared as high as 6.40% on Monday morning as traders reacted negatively to an inflation warning from a European Central Bank official.

ECB chief economist Otmar Issing said economic conditions “are improving” in Europe, accompanied by increased inflation risks. That could have inflationary implications for the U.S. economy as well.

But as higher bond yields attracted buyers Monday--and as some investors focused on a report showing slowing U.S. home sales--the T-bond yield eased back to 6.35%, up from 6.34% on Friday.

The bond market is having one of its worst years in history, as measured by the magnitude of the increase in long-term yields: The T-bond began the year at 5.10%.

Investor sentiment toward bonds has plunged to the most pessimistic levels in recent memory, traders say. In other words, most investors are afraid to buy because they expect yields to continue to rocket.

Such inordinate bearishness often is a classic contrarian signal of a market bottom--meaning, in this case, a peak in interest rates--and some analysts think a sustainable rally may be close at hand.

Long-term yields have already risen much more than shorter-term yields. The Federal Reserve, responding to the strong economy, has increased its key short-term rate just a half-percentage-point this year, from 4.75% to 5.25%.

The continuing rise in long-term yields reflects two major fears in the bond market: that the Fed will have to raise short rates much more to rein in the economy; and that inflation, the nemesis of fixed-rate bonds, may be poised to surge.

Bond traders expect another quarter-point increase in the Fed’s key rate, to 5.5%, when policymakers meet Nov. 16. But there have been rumors of a half-point increase, to 5.75%--a big reason the 30-year T-bond yield has jumped from 6.01% just since Sept. 27.

The data in upcoming economic reports, including Thursday’s release of the third-quarter employment cost index (a measure of wage inflation) and of third-quarter gross domestic product, will figure heavily in Fed decision-makers’ thinking.

Scott Grannis, chief economist at Western Asset Management in Pasadena, argues that “there’s a lot more evidence in the bond market of fear of the Fed than fear of inflation.”

He notes that the conventional 10-year Treasury note yield, a benchmark for mortgages, is 6.21%. Meanwhile, the government’s inflation-protected 10-year note--which is guaranteed to make up for any inflation erosion over time with a higher return of principal--yields 4.12%.

The difference between those yields is considered a barometer of the market’s expectation of the annualized inflation rate over the next 10 years. That expectation thus is just 2.1%--quite moderate by historical standards, Grannis said.

Yet bond-market anxiety is extreme, according to Grannis, because never before has the Fed shown such willingness to raise rates in the absence of any but the most wispy signs of rising inflation.

The market is in “a state of total confusion because they [traders] don’t know what it will take to make the Fed happy,” Grannis said.

Many traders also remember 1994, when the Fed nearly doubled short-term interest rates, from 3.25% to 6%, in a year.

Few analysts believe a rate increase of that size is pending. But William Quan, economist at Aubrey G. Lanston & Co. in New York, believes that there is indeed real upward pressure on wages, as indicated by generous collective-bargaining agreements reached recently by such major manufacturers as Boeing, General Motors and DaimlerChrysler.

That pressure argues for more Fed rate increases, probably a total of a half-point between November and early next year, he said.

But Quan also thinks that the bond market already “has priced in as much bad news as possible.” Therefore, long-term yields may have risen as far as they’re going to, he said.

What’s more, worries about the year 2000 computer problem may inspire a flight to safety by investors, especially foreigners, between now and year’s end, Quan said. That should mean more demand for Treasuries, and potentially lower yields.

An influx of overseas investment would be a reversal of what has been going on for most of this year. The Fed’s apparent determination to slow the economy and keep a lid on the stock market has made foreigners shy away from U.S. markets and has helped weaken the dollar, notes Brian S. Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson in Chicago.

Wesbury, long a bond-market bull, has turned cautious about the near-term outlook. Even though traders might feel in their bones that a peak in yields has been reached, he said, “nobody wants to step in front of the train that is the Fed.”

But if inflation remains at bay and there are signs of a U.S. economic slowdown, conditions could be right for an “explosive rally” in bonds in the next few months, Wesbury added. Longer-term, he believes, the yield on the 30-year T-bond will head back down to 5.50%.

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Two-Year High

The yield on the 30-year Treasury bond is the highest since 1997 but still well below mid-1990s peaks. Quarterly closes and latest:

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Monday: 6.35%

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Source: Bloomberg News