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Wishing for higher bond yields? Stay tuned

August 25, 2010 |  9:00 pm

For the last five months, interest yields on bonds have mostly been a one-way ticket, plummeting with few interruptions.

Now, some bond market veterans are telling clients that the rally in U.S. Treasury issues, at least, is pretty well exhausted in the short run -- and that yields are likely to hiccup soon.

That would be bad for traders who’ve been playing bonds for a quick buck, but it should be welcomed by investors who’ve been hoping to buy in at higher interest rates.

George Goncalves, head of U.S. rates strategy at Nomura Securities in New York, has been correctly betting on a continuing drop in Treasury yields since spring as optimism about the economy has faded. But in a report late last week Goncalves said he believed that the bond market was “entering the final stages of the rally.”

He says he’s sticking with that view, even though yields dropped further early this week. The 10-year T-note yield (charted below) fell from 2.61% on Friday to a 19-month closing low of 2.49% on Tuesday, then edged back up to end at 2.54% on Wednesday.

10yearT “Everyone thought I was crazy to recommend the 10-year note at 3.75% to 4% [in spring], but now think I am too early to call 2.40% to 2.50% the near-term low,” Goncalves said. “Longer-term, we remain bond bullish but believe that the market has gotten a bit ahead of itself and that there will be better buying opportunities in the weeks ahead.”

Tom Tucci, head of Treasury trading at RBC Capital Markets in New York, echoed Goncalves.

The plunge in yields since April already has sucked in plenty of traders and investors who as recently as two months ago didn’t believe that the economy was weakening and didn’t see deflation as a serious risk, Tucci said. “All of those people are on board now,” he said.

Some traders said the market action on Wednesday had a classic end-of-rally feel to it. The 10-year T-note yield briefly fell as low as 2.42% after the dismal reports on new-home sales and durable-goods orders, but the market then sold off later in the day, pushing the 10-year T-note back to 2.54% -- despite a decent reception for the Treasury’s sale of $36 billion in new five-year notes.

“This is generally a reliable signal that the market’s finally reached overbought levels that people are willing to sell,” said David Ader, head of government-bond strategy at CRT Capital Group in Stamford, Conn.

To take the bulls’ side, there are two arguments against waiting for a sell-off to buy bonds at higher yields.

If you think that U.S. economic data will worsen in the next few weeks, deepening fears that another recession looms, it’s conceivable that another tidal wave of scared money will cascade into Treasuries and other high-quality bonds. And let's not forget that the Federal Reserve, too, is buying Treasuries.

The second argument against waiting is that, even if yields rebound, there may be so many investors hungry to buy that any back-up in rates will be brief, and too hard to catch. There’s almost $8 trillion in cash earning near-zero at the bank and in money market funds. Even a 0.76% annualized yield on a three-year T-note looks great by comparison.

The bond market’s reaction to Friday’s government report on second-quarter gross domestic product will be telling. The previous estimate of 2.4% annualized growth in the quarter is expected to be revised down to just 1.4%, according to a Bloomberg News survey of economists.

If the number is weaker than 1.4%, but Treasury yields don’t fall further, that could be a strong sign that the rally has run out of gas in the near term.

-- Tom Petruno