Bonds May Get a Second Wind

Is the recent rally in government bonds coming to an end?

Yes, at least for the next few days, some analysts say, noting that bonds are overbought after three weeks of gains. But in the next few weeks, things could change course, others say, arguing that fundamentals remain favorable for bond investors.

Yields on the long bond fell to a record low last week, while the 10-year note dropped to levels not seen in 45 years after Federal Reserve Chairman Alan Greenspan said he remains concerned about an "unwelcome substantial fall in inflation." The speech prompted speculation that the central bank could cut interest rates again or possibly even buy back long-term debt.

But the trend began to reverse this week as expectations for a Fed ease began to slip and as the stock market posted strong gains. On Wednesday, the yield on the 10-year had climbed to 3.47% from 3.34% Friday, and yields on the 30-year Treasury rose to 4.45% from 4.26% Friday. The recent decline in bonds ends an unusual period in which stock and bond prices were both moving higher.

Jeffrey Saut, chief investment strategist at Raymond James, said perceptions of an economic rebound in the second half of the year could send yields higher over the near term. Indeed, he believes price declines could be sharp "given the leverage currently being employed by the hedge funds in their long bond positions."

"The Treasury bond is currently more than two standard deviations above its 50-day moving average," said Saut. "That's an overbought condition of some import, having occurred just a handful of times since 1993." Still, he also noted that the "economic surge" investors are looking for isn't likely to materialize, suggesting that any selloff in the bond market could be short-lived.

Indeed, over the next few weeks, Morgan Stanley economist Richard Berner says, yields on the 10-year bond could fall to under 3% on a belief that the Fed will do whatever it can to fight deflation and as "extension trades" force investors to chase yields even as they go down. While yields might rise eventually, "bond prices may have to get to bubble levels before market participants believe that the Fed's antideflation gambit is working," he said.

John Canavan, an analyst at Stone McCarthy Research, agrees that yields could fall to fresh lows over the next few weeks. "This pullback we've seen was more of a correction to a bit of an overdone condition, but we still have exceptionally low inflation, and concerns about deflation are still in the air," he said. "The economy, while steady, is questionable enough and we're looking for another 50-basis-point cut by the Fed over the course of the summer, which is another plus for Treasuries."

Still, over the longer term, Canavan is somewhat less optimistic, saying an improvement in the economic data could push yields higher. He said the test will be whether the 30-year bond, 10-year note and five-year note can move to, and stay above 5%, 4% and 3%, respectively. "As the year goes on, we may begin to reverse course; that will be especially true if the stock market continues to advance" and competition for capital becomes stronger, he said.

David Rosenberg, chief economist at Merrill Lynch, isn't so sure a big selloff is coming at all. He noted that if the yield curve -- which is historically very steep -- were to return to normal, yields on the 10-year note might have to fall to a meager 2%, since short-term rates aren't likely to move higher given the Fed's current stance.

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