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Bond Bears Getting Bolder

The yield on the 10-year is flirting with its highest close of the year.
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Treasury prices slid Wednesday afternoon, pushing yields toward their March highs. Traders are wondering how much further there is to go.

The benchmark 10-year Treasury bond was recently down 8/32, while its yield, which moves inversely, rose to 4.57%, flirting with this year's highest close of 4.62% on March 28. Over the past seven months, a yield of 4.2% to 4.4% was deemed attractive enough for buyers. But rising inflation expectations and global competition from international bonds are making it harder for Treasuries to bounce.

Rising yields put some early pressure on the stock market, which also had to digest disappointing earnings overnight from

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. Traders also were having trouble pushing the major indices above key resistance levels.


S&P 500

was in particular focus after it failed to convincingly breach the 200-day moving average at 1199. The index was recently down 0.96 points, or 0.08%, at 1195.58. The

Dow Jones Industrial Average

was down 2.72 points, or 0.03%, at 10,375.15. The

Nasdaq Composite

was down 3.50 points, or 0.17%, at 2105.95.

For bonds, something has changed over the course of the year and, especially, in recent weeks, says BMO Nesbitt Burns interest rate strategist Michael Gregory. The BMO team believes that the benchmark 10-year yield will continue higher, rising to 4.70% over the coming months and to 4.90% by March 2006.

The yield has risen almost 20 basis points from 4.40% at Monday's open. The latest catalysts seemed to have been Monday's nomination of Ben Bernanke to replace Alan Greenspan as

Federal Reserve

chairman. Some believe Bernanke won't be as tough on inflation as Greenspan. Inflation erodes the value of fixed-income assets over time.

The slide in bond prices began in earnest early last month, when the yield still stood below 4%, as inflation jitters were revived by the spike in energy prices that followed hurricanes Katrina and Rita.

The pace of deterioration stalled as the bond market tried to gauge whether surging energy prices would take a bite out of growth and push the Fed to stop its interest rate-tightening campaign. But after an avalanche of hawkish rhetoric from Fed officials, the upward march in yields resumed.

Another important catalyst for Treasury weakness this week comes from overseas. U.S. government bond yields are facing increasing competition from their counterparts in Europe and in Japan, both of which are showing signs of a pickup in growth. While the European Central Bank and the Bank of Japan have not lifted interest rates in years, there is now reason to believe they may. The belief has lifted bond yields in those respective regions.

"This provides alternative investments for global savings, which up until now have been going into U.S. assets," says BMO's Burns.

Global investors have long sought the attractive yields of U.S. Treasuries. With the Fed all but guaranteeing it would continue raising short-term rates at baby steps since June 2004, the dollar has remained supported, also guaranteeing the value of holding U.S. assets.

Even though it remains unclear just when the Fed will stop raising rates, it's likely to occur sometime next year. Other central banks seem more likely to hike by then. That's putting renewed emphasis on other factors that affect the dollar, such as the current account balance or increased fiscal spending next year to pay for the rebuilding of Gulf Coast states.

Should interest in Treasuries wane, as was feared early this year, the dollar might plummet and interest rates could spike.

That scenario is still just a dim possibility for now. On Wednesday, while an auction of $20 billion worth of two-year Treasury notes didn't reveal huge investor appetite, the participation of international bidders was at usual levels, according to Miller Tabak.

Still, the U.S. bond market is currently at a "critical" junction, says BMO's Gregory.

The next test, he says, will be to see how inflation acts during the holiday shopping season.

"Consumers are getting hit by record high energy bills, debt service costs, health care costs, and they may feel they have to save more to cover these costs," Gregory says. "If we see signs that the consumption is still strong, we're in for a selloff

in the bond market. But if we get a slowdown, markets would smell a pause

in Fed tightening and we may get a reprieve."

According to Miller Tabak, the market is now pricing in a 100% chance of quarter-point rate hikes at the next Fed meeting on Nov. 1, and at the Dec. 13 meeting. The odds of another hike at Greenspan's last Fed meeting on Jan. 31, which would lift the fed funds rate to 4.50%, currently stand at 76%.

The BMO economics team believes the Fed will continue to lift short-term rates to 4.75% or 5%, which would take the 10-year yield above 5%. But the Fed, according to BMO, will then be cutting rates by the end of next year, when evidence surfaces that higher interest rates are taking their toll.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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