Bond Brief: Yields Spike

Gold, which is typically regarded as a hedge against inflation, rose above $600 an ounce for a second session Friday, before ending the day down $7.00 at $592.70. On Thursday, gold breached the key $600 level for the first time since 1981. Gold has risen more than 40% in the past 12 months, compared with an 11% rise in the S&P 500.

Silver prices have touched 22-year highs. Crude prices have jumped about 10% in the past month, tracking back toward the intraday record high at $70.85 reached last August.

Smith also points out that the rise in gold is "a real indicator of dollar decline," and he says that protectionist sentiment in Washington, global trends and scarcity have played into gold's meteoric rise as much as the specter of inflation.

"India and China are seeing a lot of jewelry demand, but it's more than that. China's central bank reserves are about 1.8% in gold, while the average central bank holding is about 8%," says Smith. "They have a lot of buying to do to fill that gap."

In other international developments, news from Japan also weighed on the Treasury market Friday. The yield on the five-year Japanese government bond surged to a record high overnight on growing expectations that the Bank of Japan (BOJ) will raise interest rates as soon as midyear.

A key reason why the U.S. bond market has performed so well in recent years is that it has offered the highest return of debt markets worldwide. Moreover, the market has been fueled by the "carry trade," whereby investors borrowed money in Japan, which held its interest at 0%, and invested it in the U.S. for a higher return.

With rates set to rise in Japan as evidence mounts that the country has won its battle against deflation, there is more of a chance that Japanese investors will borrow and spend within the nation's borders. Japan is the largest foreign holder of Treasuries.

Short-term rates in Japan rose sharply Thursday on news the nation's monetary base posted its first year-over-year decline since January 2001, evidence of tighter monetary conditions

Smith says this worry is overdone. "If you look at rates around the world, ours are still near the highest," Smith said. The fed funds rate stands at 4.75%, the BOJ's key rate is at 0% and the European Central Bank's rate is at 2.50%.