Bond Brief: Soft Sell

Updated from 10:56 EDT

Treasuries ended Monday lower as mounting evidence of economic strength worldwide looked set to weigh on the market before readings on non-manufacturing activity and payrolls come out later this week.

A mixed bag of U.S. manufacturing reports brought bonds off their morning lows, with the benchmark 10-year note ending the session down 4/32 to yield 4.87%. Prior to the morning releases, the yield bumped up against 4.90%. Bond prices and yields move in opposite directions.

Yields on the benchmark 10-year note have been near their highest levels since May 2004 after the Federal Reserve raised the benchmark interest rate last week and suggested there are more hikes ahead.

The 30-year bond lost 5/32 to yield 4.90%, after losing as much as 22/32 in morning trading. The two-year edged lower 2/32 to yield 4.85%, and the five-year fell 4/32 to yield 4.84%.

"There's been signs of growth in Europe, which makes an argument for raising rates and pressure the euro, and there is a line of thought that Japan's economic recovery could prove inflationary," says Drew Matus, senior U.S. economist who specializes in fixed-income markets. "The whole world seems to be recovering at the same time."

Treasuries have offered the best return for fixed-income investors compared with the European Union and Japan. Until very recently central banks in both Europe and Japan kept rates at historic lows while the Fed has been raising its target rate for nearly two years in an effort to keep inflation in check.

Recent signs that rates will rise in Europe and Japan could mean a diminished interest rate spread between the U.S. and countries abroad, and then the U.S. would not seem as relatively attractive to these other bonds.

In Asia, bonds fell after a Bank of Japan report showed that companies plan to increase capital spending more than expected, ramping up speculation that the country will have to raise its target rate from 0%. The yield on Japan's benchmark 10-year note jumped by 8 basis points to 1.84%.

And March eurozone manufacturing grew at its fastest rate since September 2000, according to a eurozone manufacturing purchasing managers' indexes that rose to 56.1 from 54.5 in February. Suggestions that an economic recovery is strong could mean more rate hikes in the region.

If foreign investors diversify from the U.S. bond market, that could have a substantial impact now that foreign investors own more than half the Treasury market alone. For example, foreign buying of government debt helps keep long-term rates low and funds our budget deficit.

In the U.S., the Institute for Supply Management said its manufacturing index for last month declined to 55.2 from 56.7. The index was expected to show a gain to 57.5, which would have placed it at its highest level since October. Any number greater than 50 shows expansion, while a number less than 50 shows contraction.

Meanwhile, February construction spending rose a stronger-than-expected 0.8%, vs. expectations for 0.5% growth, as residential spending increased by 1.3% and business investment rose by 0.8%. The January number was upwardly revised to 0.4% from 0.2%.

Michael Cheah, a portfolio manager at AIG Sun America Asset Management, says the expectations for a stronger number than last month generated "a fair amount of negative sentiment" that the market will have to work hard to shake off.

"We're going to trade day to day," says Cheah, as participants look ahead to the ISM services index on Wednesday and the closely watched nonfarm payroll report on Friday. "This week it will be sell first, talk later."

Record low inventories have spurred production. The Federal Reserve is closely watching for evidence of tight resource utilization, which could spur economic growth and inflation.

Last Friday, the National Association of Purchasing Management in Chicago said that its regional index on manufacturing last month rose to its highest level since December.

Fed officials have made it clear that future rate decisions will be data-dependent, but their comments are still closely tracked by the market for clues about future rate decisions.

Kansas City Fed President Thomas Hoenig, Dallas President Richard Fisher and Richmond's Jeffrey Lacker will all speak tomorrow. Fed Chairman Ben Bernanke and New York Fed President Timothy Geithner will deliver speeches on Wednesday.

Last Friday, Hoenig said that economic growth has been robust and that the economy "appears to have rebounded fairly well."

However, he added that it looks like the Fed is approaching the upper end of its neutral range for rates, meaning that it is within the top end of a range that will contain inflation without restraining the economy.

Interest rate futures show 100% odds that policymakers will raise the fed funds rate to 5% at their next meeting on May 10. The odds of a move at the following meeting in June are nearly 40%.

Most economists believe that the central bank's 15 consecutive rate hikes, which have brought the fed funds rate to 4.75% from 1%, will put the brakes on economic growth by making it more expensive for consumers and businesses to borrow and spend money.

For example, the real estate market has been on fire for six years and has been a major driver of economic growth. Mortgages rates track the 10-year note yield, and as it gets more expensive to borrow money to buy a home, the sector should cool. Any weakness in the sector is being closely watched for the ripple effect it will have on consumer spending and overall economic growth.

To wit: Mortgage rates have been edging higher since the beginning of the year, with Freddie Mac ( FRE) reporting that the average rate on 30-year fixed-rate mortgage rose to 6.35%, up from the prior week's 6.32%. In the year-ago period, the 30-year mortgage averaged 6.04%.

The latest rate hike "raised the expectation that inflation may be more of a threat than was previously thought, and that kind of thinking promotes upward pressure on mortgage rates like we saw across the board this week," Frank Nothaft, Freddie Mac vice president and chief economist, said in a statement.

More from Rates and Bonds

What's Driving the 10-Year Yield to Historic Levels This Week?

What's Driving the 10-Year Yield to Historic Levels This Week?

U.S. Economy Added 103,000 Jobs in March, Missing Projections

U.S. Economy Added 103,000 Jobs in March, Missing Projections

U.S. Economy Seen Adding Jobs at 'Goldilocks' Pace For Stock Investors

U.S. Economy Seen Adding Jobs at 'Goldilocks' Pace For Stock Investors

Borrowing Costs Surge to Nearly 9-Year High Amid Changing Money Markets

Borrowing Costs Surge to Nearly 9-Year High Amid Changing Money Markets

3 Big Takeaways From Fed Chairman Jerome Powell's First FOMC Meeting

3 Big Takeaways From Fed Chairman Jerome Powell's First FOMC Meeting