Bernanke sparks a bond sell-off with new inflation warning

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Tuesday is setting up to be a lousy day for investors who own bonds.

Federal Reserve Chairman Ben S. Bernanke triggered a jump in government bond yields in Asia early Tuesday morning by declaring in a speech that ‘the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.’

Despite what Wall Street on Friday viewed as a troubling jump in the U.S. unemployment rate in May (from 5% to 5.5%), Bernanke, speaking in Massachusetts on Monday evening, said that ‘recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly.’

What’s more, he repeated a warning he made on June 3 about the risk of rising inflation pressures -- a not-so-veiled hint that the Fed’s next step with interest rates was more likely to be an increase than a cut.

The Fed ‘will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation,’ Bernanke said Monday.

In Japanese trading early Tuesday the yield on the two-year U.S. Treasury note rocketed to 2.93% from 2.71% at the end of U.S. trading Monday. As market yields jump, remember, the value of older bonds drops.

Government bond yields have been on the rise in the U.S., Europe and Japan since mid-March as investors have become less fearful about a global economic slowdown -- and more fearful of inflation, given soaring energy prices.

In terms of acknowledging inflation risks, the Fed is behind the curve compared with the European Central Bank. ECB President Jean-Claude Trichet warned again on Monday that the ECB might raise its benchmark short-term interest rate (now 4%) as soon as next month to combat inflation.

Some Europeans may think he’s bluffing, but bond investors on the Continent evidently don’t: The annualized yield on the two-year German government bond jumped to 4.69% on Monday, up from 4.64% on Friday and the highest since -- believe it or not -- December 2000.

Michael Darda, economist at investment firm MKM Partners, noted earlier Monday that interest-rate futures markets have in recent days boosted their bet on when and how quickly the Fed would begin to raise its benchmark rate, now 2%.

The chance of a 0.25-point rise in the Fed’s rate in October was 88% on Monday, up from 48% on Friday, Darda said.

Bond investors now have to figure out what’s a fair yield to accept if the Fed really is leaning toward tightening credit.