Bond Market Rallies but Legs Aren't Yet Visible

This may come as a shock, but things haven't looked quite this good in the bond market since just after the Fed raised interest rates in August -- and before that, since last year. Treasury futures broke out of a recent trading range last week, boosted most prominently by a falling stock market. But bonds' two-day, 2-point rally was built on little else.

Looking ahead, the market has reasons to be optimistic. The Fed may be on hold and corporate supply should dwindle ahead of Y2K, increasing demand for Treasury bonds. Price inflation is still weak.

But late August's euphoria deflated within two weeks, and this rally may suffer the same fate. The economy hasn't slowed much, and the Fed, as always, is unpredictable. Commodity and oil prices, as well as the dollar, are no longer supportive of lower interest rates.

Mr. Outside

The fourth quarter, and October in particular, has typically been a lean time for the stock market and a fat one for bonds. The Dow's 4.9% decline last week, echoed by weakness in other equity proxies, is positive for bonds.

Obviously, investors tend to flee from risky assets, which is what stocks are starting to resemble right now, into safe Treasury securities. "People are kind of nervous, especially ahead of October's earnings season," said Ken Fan, bond strategist at Paribas Capital Markets. "I think you'll have some people putting money back into the Treasury markets."

More important, a slow, steady correction in stocks could ease the Fed's worry about a steep selloff. A crash would probably force the central bank to cut rates drastically, boosting liquidity and, in effect, inviting inflation's reappearance as spending rises.

"The stock market has obviously given the market another reason to expect the Fed is doing nothing" when its policy-setting Federal Open Market Committee next meets Oct. 5, said Jim Kochan, senior bond market strategist at Robert W. Baird. "But again, this is kind of a thin reed on which to base a rally."

Commodity prices, including those of several raw materials that are used to produce finished goods, are on a steady rise. The price of oil is near $25 a barrel -- it's been almost two years since that happened. The dollar lost more than 25% of its value against the yen this summer, though it's been stronger against other currencies. A weak dollar raises the import prices, feeding inflation.

Mr. Inside

Breaking through a trading range without any obvious catalyst was positive for bonds.

The 30-year bond futures contract breached a resistance level that had stood as the top end of the market's range for almost all of September, somewhere between 114 5/32 and 114 11/32.

Problem was, this rally wasn't supported by any kind of volume. Tracker GovPX reported Thursday's volume was down 27% compared with the average Thursday in the past month, which means there wasn't a lot of support from investors for this rally. Friday's volume was a little more convincing -- down just 5% -- but that's more a reflection of overall weak volume on Fridays in the past month than broad-based buying of Treasuries.

It's why Kochan questioned the rally's sustainability. "People are still focusing on the sister markets," he said. "Treasuries are too expensive, and given that corporate and agency spreads have narrowed, I'd say the same thing about those markets too."

Ironically, the hefty corporate supply, which was supposed to have overwhelmed the fixed-income market in September, amounted to little more than noise. More than $40 billion in supply was estimated for this month, as analysts predicted corporations would regard September as their last chance to sell debt. In reality, just under $13 billion had been priced halfway through the month, and that action hasn't been nearly as destabilizing as was predicted.

Analysts haven't changed their projection that corporate debt sales will be sharply reduced during the fourth quarter, which will create more demand for increasingly scarce Treasury securities.

Mr. Data

It could be that the bond market simply forgot all about economic data, having rallied in a week with very few releases. That'll change in the next two weeks, when the purchasing managers' indices and the employment report are released. One nasty-looking economic release could change the situation quickly.

"We're still going to have a threat of Fed tightening that the market is ignoring," said Marilyn Schaja, money market economist at Donaldson Lufkin & Jenrette. The consensus is that the Fed will be on hold Oct. 5, after twice raising the fed funds rate this summer. There's two more meetings left before the end of the year, and the market is hoping the Fed will stand pat until next year.

However, as Kochan warned, lower interest rates will only spur more economic growth in the housing and consumer-spending sectors, areas that haven't really slowed down the recent rise in interest rates. The growth could restore the stock market to earlier, more jubilant levels, and turn the Fed's current wait-and-see attitude to a more aggressive one quickly.

Kochan boiled it down to round numbers: "Since the Fed started tightening, any time you bought securities when the yield's been below 6%, it's been a mistake."