Bullish Bond Market Trend Carries Cautionary Tone

Long-term interest rates keep sliding even as the Federal Reserve pushes short-term rates higher.

That’s good news for the housing market, and it’s helping the stock market as well.

But analysts worry that the trend is being driven by traders in U.S. Treasury bonds who are just in for a quick buck -- not unlike what happened with the frenzied buying of oil futures and the euro currency in recent months.

The lesson from the oil and currency markets was that, when too many speculators become convinced that a market will keep going the same way, it often stages a sharp reversal.

Long-term Treasury bond interest rates, or yields, are at their lowest level in months. But if bond yields were to snap back, so too could mortgage rates, which last week hit their lowest level since April. And stocks also could suffer.

For now, though, the bulls are in control in the bond market.

Long-term rates sank further Monday, with the yield on the bellwether 10-year Treasury note falling to a three-month low of 4.05%, down from 4.22% at the start of the year.

The 10-year T-note yield has dropped from 4.87% in June. The decline has occurred as the Fed has raised is benchmark short-term rate from 1% to 2.5% in six quarter-point increases since June 30.

Historically, it’s unusual for long-term interest rates to slide in the early stages of a Fed credit-tightening campaign. And that’s what troubles many analysts. They see something phony about the drop in bond yields.

Paul Calvetti, head of Treasury bond trading at Barclays Capital Inc. in New York, said short-term-oriented traders such as hedge funds have become big players in long-term bonds, riding the buying trend in recent months.

“It’s a piling-on now,” Calvetti said.

Traders, he said, are beginning to talk about the 10-year T-note yield falling below 4%. The confident tone about lower yields sounds a lot like discussions about oil in October, Calvetti said: Many traders were certain that crude would top $60 a barrel. Instead, oil peaked at $55 and has since pulled back to about $45.

If bond buyers suddenly were to shift gears and bail out, the turnabout could be dramatic.

That has happened twice in the last two years. Yields snapped back suddenly in the summer of 2003 and again in the spring of 2004. The yield on the 10-year T-note, for example, soared from 3.68% on March 16 of last year to 4.86% by mid-May.

Still, many experts also say there are fundamental reasons why investors, as opposed to traders, continue to buy long-term bonds at current yields.

Some investors are betting that U.S. economic growth will slow, that inflation will remain relatively benign, and that the Fed won’t raise its key short-term rate much beyond 3%.

If those investors are right, then a yield of about 4% on a long-term bond might still provide a decent “real” return.

That’s the view of David Rosenberg, an economist at Merrill Lynch & Co. in New York. He predicts that the core rate of inflation in the consumer price index will be rising at a pace below 2% by the end of this year, as businesses find it harder to raise prices. (The core rate excludes food and energy.)

Bond bulls were cheered by the government’s report Friday that the nation added a net 146,000 new jobs in January, a figure well below expectations. Modest growth could assure that inflation stays tame, which also could mean an early end to Fed credit tightening.

Bill Gross, who runs the world’s largest bond fund, sees another factor driving bond yields down: Long-term securities are in greater demand by pension funds worldwide as the funds seek to lock in yields at current levels rather than take a chance on the vagaries of the stock market, he said.

Some traders say pension-fund buying has been a particular boon for the longest-term U.S. Treasury security, a bond maturing in 26 years. The yield on that bond has fallen from 5.06% on Dec. 2 to 4.42% on Monday, the lowest since mid-2003.

Demand from Asian central banks also has been buoying the Treasury market, experts say. Asian nations that enjoy record trade surpluses with the United States are looking for places to invest those sums, and the huge U.S. bond market is a natural destination, said Gross, manager of Newport Beach-based Pimco Total Return fund.

“That money is coming right back into the Treasury market,” he said.

The market faces a big test of that demand this week: Beginning today, the Treasury plans to sell a total of $51 billion in new three-, five- and 10-year notes.

The problem many investors face in turning their backs on the bond market is that they remember all too well the same arguments against buying bonds last year. Despite the surge in long-term yields last spring, the 10-year T-note yield still ended 2004 slightly below the 4.25% level at which it began the year.

Gross said he doesn’t find long-term Treasury bonds appealing at current levels. But with long-term interest rates relatively low worldwide, “We’re getting sort of desperate now.”