Bond yields soar as investors see red in tax-cut deal

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The bond market is suffering a brutal sell-off Tuesday, driving yields up sharply, as investors react to the deal between President Obama and Republican leaders to extend the 2001 and 2003 tax cuts.

The 10-year Treasury note yield (charted below), a benchmark for mortgage rates, has soared to a five-month high of 3.16% from 2.94% on Monday. Shorter-term yields also are rocketing.

Many investors are figuring that the extension of the tax cuts would be bullish for economic growth, which typically would mean upward pressure on interest rates.

Second, preserving the cuts, and adding an additional payroll-tax cut, is likely to widen the federal budget deficit -- another negative for the bond market and interest rates.

Economists at Bank of America Merrill Lynch estimate that the 2011 deficit would grow by $200 billion to $300 billion from their current estimate of $1.26 trillion.

The Federal Reserve continues to buy Treasury notes and bonds as part of its ramped-up “quantitative easing” program announced Nov. 3. But even the Fed’s unlimited buying power obviously isn’t enough to keep yields down if private investors increasingly rush for the exits.

Many stock market bulls have been predicting that investors would begin selling bonds to buy stocks if optimism about the economy increased. That has been happening on a gradual basis since early October, when the 10-year T-note yield bottomed at 2.39%.

Now, it’s looking like cash is flooding out of Treasuries.

Some of that money definitely has been going into stocks on Tuesday: The market is broadly higher, with the Standard & Poor’s 500 index up 4.38 points, or 0.4%, to a new two-year high of 1,227.50 at about 12:15 p.m. PST. The index had been up as much as 1% earlier.

A big question: How many individual investors, who’ve pumped record sums into bond mutual funds over the last two years, will decide to join the exodus if market interest rates continue to rise and drive bond fund share prices lower?

-- Tom Petruno