Treasuries Forecast Better Times, and Higher Prices, Ahead

Treasuries are forecasting better times ahead but are also starting to show worries about higher prices. Analysts point to the yield curve -- the difference in yield between specific Treasury securities such as the two-year note and the 10-year benchmark note - which has been getting steeper.

Experts take this as a sign that the economy is poised for growth down the road. But as the yield curve steepens, as a result of falling prices and therefore rising yields among the longer-dated bonds, the move also signals that inflation has started to creep into the picture.

Analysts believe that the Federal Reserve , which on Tuesday cut interest rates for the fifth time this year, get their cues from the Treasury market. "Contrary to popular belief, Fed interest rate policy often follows the market as opposed to leading the market," said Mike Hurley, a technical analyst at Wit Soundview. "The 10-year note started declining in yield in January 2000, well ahead of the Fed bringing short term interest rates down."

Tony Crescenzi, chief bond strategist at Miller Tabak agreed. "The bond market has proven to be a good predictor, probably because the Fed respects and tends to follow it rather than lead it," he said. "It tends to predict improvements 12 months in advance, while the stock market predicts six to nine months in advance."

Unlike stocks, which are based on the uncertainty of future earnings, bonds make fixed payments for a certain time period. Investors decide how much to pay for a given bond based on how much they expect inflation, or higher prices, to erode the value of those fixed payments. Normally, investors demand higher yields on long-term bonds than on short-term securities because over a longer period of time, inflation can have a larger effect. So, the higher their expectations for inflation, the less investors will pay for bonds, and the higher the yields.

A positively sloping yield curve, which is created when shorter maturities yield less than longer maturities, is a good indication that investors believe the economy will be growing in coming quarters. For most of 2000, the yield curve was inverted, which accurately forecast the significant slowing that soon hit the economy. But the yield curve started back on a normal slope at the end of last year, suggesting the economy was on the road to recovery.

If Recovery, then Inflation?

Analysts point out that the steepening yield curve was initially the result of the Fed's rate cuts, which benefit short-term maturities that tend to move most dramatically to expectations of lower interest rates. But the recent move of the yield curve has been caused by rising yields on the long end of the market as investors expect the economy to eventually rebound and stoke inflation pressures.

"And the fact that yields on the 10-year note are now rising tells me that the Fed may have done the bulk of its work," said Hurley. Lately, treasuries were mixed, with weakness concentrated in the short maturities after this morning's lower-than-expected initial jobless claims data. The two-year note traded down 5/32 to 99 12/32, raising the yield to 4.337%. At the long end of the market, which was up sharply on the expectation of a strong Federal Reserve buyback, the 10-year benchmark note gained 9/32 to 96 27/32, yielding 5.416%. The 30-year bond rose 1 3/32 to 94 11/32, with a yield of 5.773%.

The Steepening Trend Yield Spread Between two- year and 10-Year Note

Source: Baseline

Kathleen Camilli, director of economic research at Tucker Anthony, said she believes the "adverse reaction" recently seen at the long end of the bond market reflects the fear that the Fed has moved too aggressively and too fast.

Recent economic data have been mixed. The latest consumer sentiment numbers, retail sales data and April's producer price index came in stronger-than-expected, showing consumers aren't closing their wallets. Meanwhile, industrial production and capacity utilization data for April came in far weaker than expected, underscoring a continuing contraction in the manufacturing sector and supporting the latest purchasing managers' index for April, which indicated businesses still face falling production as they continue to cut back on employment and reduce inventories.

"The next question is, will the long end of the curve come down now that economy shows evidence of weakening?" Camillie said. "With respect to inflation, it's disturbing that the long end seems to be building in a higher inflation premium. I don't think we're going into an inflationary decade. That said, we do have a power problem because the electric utility grid in the economy is insufficient for demand. However, I'm not expecting significantly higher inflation."

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