The recent selloff in government bonds has been overdone. At least that's what one influential analyst said as bond yields rocketed to seven-month highs Monday amid continued fallout from
Chief Alan Greenspan's testimony last week.
While many pundits have declared that the bond market rally is largely over, including Bill Gross, manager of the world's largest bond fund at Pacific Investment Management, a few others, such as David Rosenberg, chief economist at Merrill Lynch, aren't so sure.
"The recent backup in bond yields is going to be short-lived," said Rosenberg, who noted recently that bond yields have risen dramatically in the past but that the rise in yields hasn't lasted. This is the 14th "yield backup of significance since early 2000," he said. From late 2001 through early 2002, the 10-year note surged 122 basis points, "and few thought we would ever see 4.22% ... again, but we did five months later," he noted.
Bonds have plunged recently, with the yield on the 10-year Treasury note leaping to 4.21% from just 3.63% on July 11, as investors continue to respond to Greenspan's comments before Congress. During his speech, the Fed chief downplayed the threat of deflation and said he expects the economy to recover in the coming quarters.
Worries about deflation have helped bolster bond prices in recent months, because investors assumed the Fed would take unusual steps to combat the threat, such as purchasing U.S. Treasuries in the open market. That option no longer seems realistic. Indeed, the bigger concern now is inflation, which some say will inevitably follow an economic recovery. Inflation erodes the value of bonds' fixed interest payments. Combine all this with ballooning budget deficits -- which would prompt the Fed to issue more debt -- and technical selling from investors in mortgage-backed securities, and some traders say the days of decade-low yields are over.
But Rosenberg said that's not necessarily the case. "
For now at least, we can still say that the highs in yield this cycle are still getting lower and the lows are getting lower -- that trend has yet to be broken."
That doesn't mean investors should rush out and buy bonds just yet, though. Investors should perhaps wait until after the Institute for Supply Management releases its manufacturing data in early August. The numbers could show a "huge" ramp-up due to favorable seasonal factors, and that could prompt another round of selling and a much better entry point, he said.
Just why is Rosenberg so confident that bonds will rally again? First, he notes that inflation just isn't the threat that investors seem to think it is. Gold prices, which are sometimes used to predict inflation, have been in a downtrend for a while now and have made a series of lower highs and lower lows since topping out in late May, according to David Skarica, editor of the newsletter
Addicted to Profits
The producer price index and consumer price index have both shown very low levels of inflation recently, with the core CPI in June rising just 1.5% year over year. That matched the 37-year low recorded in April.
In addition, the outlook for the overall economy is still very cloudy. Indeed, some economists say the big rise in bond yields could undermine the very recovery that bond investors have recently been anticipating. Although yields are still low historically, borrowing costs for U.S. companies are much higher than they were one week ago and are up even more sharply from mid-June, when the 10-year note was yielding just 3.11%. If yields continue to rise, it could crimp corporate borrowing and investment and send mortgage rates higher.
And Greenspan has already warned about a "pervasive sense of caution" among corporate executives, saying recovery signs are "tentative" and that companies still aren't spending money despite a more accommodative financial environment. "How this caveat could possibly then translate into a 3.75% to 4.75% GDP growth forecast
from the fourth quarter of 2003 to the fourth quarter of 2004 is an accomplishment that could have been orchestrated by maybe two individuals -- Harry Houdini or Alan Greenspan," Rosenberg said.
Finally, economists note that the Fed is still very much intent on keeping interest rates low. Bear markets in Treasuries only occur when the Fed is tightening, and that isn't on the radar screen, according to Rosenberg.
Ashraf Laidi, chief currency analyst at MG Financial Group, noted, "Historically, the Fed did not shift to a tighter monetary policy until the unemployment rate showed at least two consecutive monthly declines. With the unemployment rate at nine-year highs and jobless claims standing above 400,000 each week for nearly half a year, it would have to take at least three to four months for layoffs to abate and another three to four months for hiring to pick up."