Rout in Treasury bonds shows investors' fears about the Fed

The Federal Reserve hasn’t raised its benchmark short-term interest rate. But it might as well have, given how yields are rising on Treasury bonds.

And that is a distressing turn of events for mortgage rates and for the struggling housing market.

Yields on Treasuries have been in an upward trend since mid-March, but the trend gave way to a spike the last few days: The yield on the two-year T-note ended at 2.92% on Tuesday, up from 2.71% on Monday and 2.38% on Friday.

A move of a half-percentage-point in two trading sessions is nearly unheard-of.

Bond yields rise, of course, when investors are bailing out, pushing bond prices lower. And there has definitely been a rush for the exits. "This is the get-me-out trade," said Tom Di Galoma, a veteran bond trader at brokerage Jefferies & Co. in New York.

Why the sudden urge to sell? The Fed seems to have gotten religion about inflation pressures in the economy, with oil’s surge above $130 a barrel. Chairman Ben S. Bernanke warned about the risks of higher inflation in two speeches over the last week.

The implicit message: Don’t expect the central bank to make another cut in its benchmark rate, now 2%. In fact, be prepared for a rate hike, particularly if oil doesn’t come down.

That is driving two camps of investors away from Treasury bonds. Camp One comprises "people who had been betting on a weakening economy," Di Galoma said. Bernanke, in his speech Monday, indicated the Fed was less worried about the economy than inflation.

Camp Two: Investors who figured the Fed was done cutting rates, but who believed a rate increase wouldn’t happen before 2009. Now, the concern is that Bernanke might want to start tightening credit in the fall.

David Ader, chief government bond strategist at RBS Greenwich Capital in Greenwich, Conn., said he still expects the Fed to wait until next year to raise its key rate. But with its new hard-line on inflation, Ader said, "The Fed is trying to tighten credit without actually tightening."

Many on Wall Street believe the Fed’s immediate goal is to bolster the dollar. As I explain here, that could help bring down commodity prices and thereby damp inflation.

Di Galoma is warning clients that Treasury yields may continue to rise as shell-shocked investors reassess the Fed’s stance. The two-year T-note yield, he said, could jump to 3.2% in the near term.

And although longer-term Treasury yields haven’t risen as quickly as shorter-term yields, the 10-year T-note, at 4.11% on Tuesday, was the highest since Dec. 27.

The housing market can’t like the sound of this. The mortgage market takes its cue from longer-term Treasuries, which could mean more upward pressure on mortgage rates. The average 30-year home loan rate was 6.09% as of last week, up from 5.98% two weeks earlier and the highest since mid-March, according to mortgage finance giant Freddie Mac.

The latest jump in bond yields "is not a welcome circumstance," said Keith Gumbinger, vice president at mortgage research firm HSH Associates. He was trying to be gentle.

If a potential home buyer is having trouble making the math work because of higher mortgage rates, guess what the home seller will probably have to do to his asking price?

Comments

[bkl]

Amid the turmoil in the financial markets earlier this year, there was a flight to quality, meaning that people sold corporate and municipal bonds and bought treasuries. To the extent that people have realized that corporate and municipal bonds are not worthless and that the world has not come to an end in the midst of a record number of foreclosures, the flight is reversing. The spread between treasuries and other bonds is going back to what used to be normal. Yields on treasuries were abnormally low, and now they are going back up.