Where the Value Is in the Bond Market, Part 1

The Treasury's surprise decision to stop issuing 30-year bonds prompted a massive rally in the long end of the Treasury market. I offered my thoughts on the Columnist Conversation and promised to give a fuller rundown on bond market sectors and where I see value.

I'll take a look at the long and short ends today, and then I'll examine the spread, or non-Treasury, sectors tomorrow. Regardless of where you think the economy is heading, I'll try to provide a road map for those with different opinions.

Treasuries

Back in September, I thought that the steep yield curve was discounting two different scenarios. The short end was priced as if investors expected protracted economic weakness, an extended low-level fed funds rate , lower inflation due to a soft economy and continued "safe-haven" demand to offset the increased Treasury issuance. The long end was priced as if investors expected only a brief economic pause, greater Treasury issuance and higher inflation from the aggressive Fed easings.

If some of the short end's expectations didn't come to pass, I thought that sector would be vulnerable. If they did, there was still little upside, so I continued to hold no short Treasuries. If the long end's expectations materialized, I figured the relatively high yields of long bonds would help insulate me. If they didn't occur, I thought they could appreciate in price, so I went from a neutral weight in long Treasuries to an overweight.

In the wake of last week's rally, I've trimmed my long Treasury holdings from overweighted to neutral. If rates stay where they are or go lower, I plan to reduce them further. Why not sell everything? I'm going slowly for several reasons.

First, the yield curve is still steep. Though the spread between the two-year Treasury note and the 30-year bond has narrowed by 28 basis points since before the Treasury's Oct. 31 announcement, it is still 57 basis points wider than it was Sept. 10.

All year, bond managers have been forcing the yield curve steeper in a battle with the Fed. With the Treasury having joined the battle on the long end last week, we're at a critical point. Hopefully, the Treasury has broken the back of those putting on the "curve-steepening" trade. If so, long rates could fall further, and I'd be much more optimistic about the economy. If not, and bond managers fight both the Fed and the Treasury in an attempt to take bond yields up again, I'd be less optimistic about the economic outlook for 2002.

Second, though I can't justify staying overweight in long Treasuries after this rally, you can argue that long bonds are still attractive. With oil prices having fallen, the consumer price index should trend down to 1% over the next year if oil stays where it is. If so, that implies a real yield of nearly 4% on 30-year Treasuries, a historically wide number.

Potential Outcomes

Of course, we get a significant portion of our oil from a volatile part of the world. Should something disrupt our access to energy and send oil prices up sharply, bond managers would adopt a "sell now, ask questions later" mentality, like they did in August 1990 when the Gulf War broke out. This outcome isn't likely, so I still want to own at least some long Treasuries with the curve this steep. However, if you give it great odds, you probably don't want to own bonds.

Finally, more terrorist acts could occur. We're making a tremendous effort to prevent further attacks, and I think, hope and pray that we'll be successful. Nevertheless, I want to own a few long Treasuries in case something else, man-made or not, slows the economy further. If you think the economy will be weak, you'll want to own long bonds, and vice versa.

I emerged from last week's price action as a moderate seller of long Treasuries at these levels. In normal times, I'd be selling faster. Lower yields would make me a better seller; higher yields would make me less aggressive.

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Want to know the outlook for corporate, municipal, mortgage and agency bonds? Look for the second part of this column Thursday.