Bond Bulls Bide Time

Updated from 7:34 a.m. EDT

The long-term bull market for bonds is far from over.

Even though government bonds posted their biggest quarterly loss in more than 20 years in the three months ended June 30, and most economists expect several more interest-rate hikes before the year is out, some pundits say there are reasons to remain enthusiastic about bonds.

"We think the secular bull market in bonds has years to run," said Lacy Hunt, chief economist at Hoisington Investment. "We don't think it's over by a long shot."

The Treasury market has seen some wild gyrations this year, with the yield on the 10-year note falling to an eight-month low of 3.65% in mid-March before soaring to a two-year high of 4.90% by mid-June.

The huge reversal came amid signs that the job market was improving and inflation was creeping higher. But over the past few weeks, the 10-year's yield has pulled back once again and continued to decline even after the Federal Reserve raised interest rates by 25 basis points last Wednesday. Thursday morning, the yield is sitting at 4.49%.

"I think that whatever the Fed is going to do this year is priced in," said Hunt, whose firm has correctly forecast a decline in interest rates over the past two decades. "The economy is in the process of decelerating and apparently rather sharply."

Indeed, employment growth was much weaker than expected in June and the Institute for Supply Management's manufacturing and services indices were both down last month from their levels in May. Durable goods orders have fallen for two straight months, auto sales have been disappointing and retailers like Wal-Mart ( WMT) and Target ( TGT) have issued warnings that point to a possible slowdown in consumer spending.

Some economists also note that money supply has been growing at a sluggish pace recently and has not been consistent with an overly accommodative Fed. In the week ended June 21, M1 grew 4.5% year over year while M2 grew 4.1%.

In addition, a number of brokers, including UBS, Lehman Brothers and J.P. Morgan, have lowered forecasts for second-quarter GDP growth recently.

Last week, Pacific Investment Management bond guru Bill Gross changed his pessimistic stance on bonds and bought $35 billion in Treasury and mortgage-related securities, noting that concerns about higher inflation and interest rates already have been factored into prices and that the economy seems to be slowing down, according to The Wall Street Journal.

Still, overall sentiment in the bond market remains more bearish than bullish, with many hedge fund managers and traders expecting long-term interest rates to move higher by year-end. Only 12% of clients polled by J.P. Morgan expect bond yields to fall this year while 40% are looking for yields to rise. About 48% are neutral.

David Rosenberg, chief economist at Merrill Lynch, said the 23-year bull market in bonds has survived no fewer than five Fed tightening cycles and most likely will survive this one.

"Mini-bear phases have come and gone," he said, noting that yields have seen lower highs and lower lows consistently "since the Volker-induced and Greenspan-nurtured secular bull market began in September 1981."

For this secular bull market to be broken, he said, the 10-year Treasury yield would have to break above the prior high of 5.44% posted in April 2002.

Peter McTeague, co-head of interest rate strategy at RBS Greenwich Capital Markets, agrees. Even though yields are well above their lowest levels of the year, he believes the bull market is alive and well, at least for now.

"I think that we're very late in the economic cycle ... and that over the course of this year and next year we're going to find that growth did peak out at the beginning of this year," he said, adding that he expects the 10-year Treasury yield to be sitting at 4.50% by year-end.

Jim Sarni, a managing principal with Los Angeles-based Payden & Rygel, said that the bond market "got ahead of itself" in the second quarter and was anticipating much more growth and inflation than is likely to materialize this year.

Although interest rates might not sink to levels seen earlier this year, Sarni said rates could come down slightly or level off, as the economic data continues to undershoot expectations. "We don't think the bull market in bonds is over," he said. (Sarni is part of a team that manages $52 billion in fixed income assets.)

Of course, strategists say it's hard to predict what will happen, particularly because the Fed is no longer fighting against inflation but is instead trying to maintain price stability. In its last policy statement, the Fed said the risks of rising inflation were "roughly equal" with the risks of falling inflation.

"It's a different era than where we've been the past 25 years and I think that's why there's more uncertainty about the direction than there has been in a while," said John Derrick, who manages $600 million in fixed-income products at U.S. Global Investors.

Derrick thinks it's too early in the interest rate cycle to look for lower bond yields but he isn't expecting an explosive move upward either, saying rates should reach 5% by year-end.

Still, Hoisington Investment's Hunt doubts that yields will move higher this year, saying consumer spending probably will fall off over the next six months without tax cuts to support it. He is looking for one more rate hike at most this year while futures markets continue to price in another 100 basis points of tightening.

"Our feeling here is bond yields are going to drop significantly over the second half of the year," he said. "At the end of the year, yields are going to be well below where they started the year."

The yield on the 10-year Treasury note began the year at 4.25%.

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