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Bond investors could be in for another rough ride

February 7, 2011 |  6:00 am

The U.S. Treasury bond market faces a big test this week: With market interest rates on longer-term government securities now at their highest levels since last spring, will buyers flood back in -- or will last week's selling accelerate and drive rates even higher?

The Treasury needs buyers to step up, because it will be auctioning a total of $72 billion in three-year, 10-year and 30-year bonds on Tuesday, Wednesday and Thursday, respectively, to fund the ballooning federal deficit.

Rising Treasury rates matter for more than just that market, of course. They also influence many other interest rates, including mortgage rates. Already, higher Treasury yields last week helped to push up tax-free municipal bond yields, which had just begun to pull back from two-year highs reached in mid-January.

Treasyield Last week set off alarms in the bond market because Treasury yields broke out of the trading range they'd been in since mid-December. The 10-year T-note yield (charted at left) jumped to 3.64% on Friday, up from 3.32% a week earlier and the highest since May.

The steep rebound in bond yields since October has in large part reflected the economy's surprising strength. Interest rates are rising as some investors bet that we're getting closer to the point where the Federal Reserve will begin to tighten credit -- even as the Fed continues to try to suppress longer-term rates by buying Treasuries in the market under its "quantitative easing" program.

What was striking about the surge in bond yields on Friday was that it followed the dismally weak report on January employment. Although the government said the economy created a net 36,000 jobs last month -- a shockingly low number -- many analysts said the report was skewed lower by bad weather in the East and Midwest. At the same time, the drop in the unemployment rate to 9.0% from 9.4% in December further confused the picture.

Treasury bond investors seemed to buy the argument that the economy isn't really losing momentum and that employment will pick up soon. And because Fed Chairman Ben S. Bernanke has made clear the central bank will wait to see the jobless rate fall significantly before tightening credit, bond investors may figure that the trigger point for the Fed no longer is far off in the future.

Even with bond yields up sharply since October, additional strong economic data could pose a "growth shock" for bonds that would fuel another move up in yields, said Michael Kastner, a partner at Halyard Asset Management in New York.

Because higher market yields devalue older, lower-yielding bonds, the upturn in interest rates means investors are losing principal value on many kinds of bonds. That, in turn, raises the risk that more investors will flee the market, as they've done in the battered muni bond market.

Each increase in yields also stokes talk that the bond market fears inflation erupting sooner than later from the Fed's easy-money policy.

Tad Rivelle, chief investment officer for fixed income at TCW Group in L.A., thinks the bond market's message is that the Fed "is getting behind the curve [on inflation], but purposely so" -- because Bernanke wants to make sure the economy gets a head of steam and that banks benefit from near-zero short-term interest rates for as long as possible.

Given the economic and Fed-policy backdrops, it's too early to be locking in yields on longer-term government bonds, Rivelle says. "I think there needs to be a major repricing of Treasuries," he says -- meaning higher, not lower, yields ahead.

If investors want to show that bond market bears are wrong, and that Treasury yields now are too attractive to pass up, they'll have ample opportunity to demonstrate their conviction this week.

-- Tom Petruno

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