Jump in U.S. Treasury yields signals market fear that Fed is behind the curve on prices.
The U.S. bond market has begun sending a message that inflation risks are rising and the Federal Reserve may be too slow to act, potentially marking a significant turning point in the economic recovery.
In the past week, Treasury-bond yields have jumped to their highest levels since last spring. Yields on 10-year Treasurys surpassed 3.5% and 30-year yields broke through 4.7%, which makes some worry could mean rates will march even higher.
Long-term rates have been gradually moving higher in response to an improving economy and rising commodity prices. But in recent days the increases in yields accelerated, a move many say is due to the worry that the Federal Reserve may be underestimating inflationary pressures in the economy, and may act too slowly to tame them. Inflation is bad for bondholders, eroding the value of their fixed returns and sending the prices of their bonds lower.
While raising alarm bells about inflation, the bond market is also indicating it sees no signs that the Fed will intervene. Short-term rates, which are most sensitive to Fed moves, have held relatively steady, causing the difference between two-year and 10-year notes to reach its steepest level since February 2010.
Such a steep "yield curve" is typically a bullish sign for the economy and the stock market. It could also, however, suggest that investors see a risk of overheating.
Even if they don't consider themselves bond-market "vigilantes"—the term for investors who try to change government policies by driving interest rates higher—the effect of their actions may still be the same.
Though most market watchers express faith that the Fed can still get ahead of the inflation pressures, the doubters are exacerbating a bond-market selloff.
"It seems to a lot of people that the Fed will be behind the curve and won't be ahead of inflation," said Ira Jersey, an interest-rate strategist at Credit Suisse. "We don't buy that, but future economic reality doesn't always have a significant impact on what happens in the market."
The yield on the 10-year Treasury note closed Friday at 3.647%, the highest since May 3.
That means the effects of last year's turmoil, which sent investors running to bonds and drove yields lower, have been erased. Bond yields and prices move inversely.
The yield on the 30-year Treasury bond ended Friday at 4.732%, its highest since last April. Adding to the almost-panicky feel in the bond market on Friday, traders circulated a chart of 30-year-bond yields showing that the yields had broken out of a 30-year trendline—a sign that the decades-long bull market in Treasurys may be drawing to a close.
Most in the market have suspected that the long bull market was likely over. Friday's move seemed to help confirm these suspicions.
The recent moves in many ways look like an echo of last spring, when yields rose as the economy started picking up steam, only to come sharply down amid the "flash crash" and European debt crisis. But there as some significant differences that indicate to some that this rise in yields may be the beginning of a longer trend.
The Fed isn't even halfway through the second round of its quantitative-easing program to buy $600 billion of bonds, commodity prices are much higher, and the economic recovery has been in progress for a year.
Rates are also rising because of gnawing concerns about government finances. That will be in fresh relief this week, with the Treasury planning to sell $72 billion of new notes and bonds.
"The more bonds they issue and the more they raise capital, the less favorable it is to the bond market," said Todd Colvin, vice president of interest-rate products at MF Global.
Medium-term Treasury notes, which have been the main focus of "QE2," have suffered the most in the recent selloff, in a sign that investors are giving up any lingering hopes that the Fed will embark on a third round of bond buying when this round ends in June.
Barclays Capital strategists on Friday raised their forecast for interest rates in 2011, due in part to the market's increasing focus on soaring prices for oil, food and other commodities.
In measuring inflation, the Fed prefers to strip out such costs, which they view as transitory. Fed policy makers prefer to focus on "core" inflation measures, which are still extraordinarily low.
Some in the market think that is a mistake.
"They perceive the Fed as getting behind the curve despite core inflation remaining well below the Fed's target," Barclays rates strategist Ajay Rajadhyaksha wrote. "This perception is unlikely to reverse quickly."
Angst about Fed policy hasn't been the only factor driving rates higher. For one thing, recent economic data have been surprisingly positive.
A stronger economy, which the Fed likely is welcoming, typically argues for higher interest rates.Though the labor market has been a stubborn laggard, investors appeared to take January's head-scratching drop in unemployment to 9% at face value.
Many in the bond market also focused on a 0.4% increase in average hourly earnings in January, the biggest since 2008. Rising wages can help inflation take root.
Still, many in the bond market feel the punishment for bonds may have run its course, at least for the time being. Disappointing economic data, another flare-up of European sovereign-debt worries, or any number of issues could push investors back into bonds.
"It does feel like a repeat of last spring," said George Goncalves, Nomura Securities International's head of rates strategy for the Americas. "There are still a lot of risks out there that are unresolved."
The current Mandate of the Fed is to juice stock prices higher (price stability). Doing so has benefited professional money managers (Wall Street) and corporate insiders the most. His actions are also creating losses once again for the novice investor who piled into the safe haven move of US bonds and/or will induce these same investors into stocks just as they being to top.
Are higher yields due to a strong economy or commodity inflation or gnawing concerns about government finances? Right now all 3 seem equal in there pressure.
Below is the daily chart of the yield on the 10 year treasury yield. We are quickly approaching resistance in the area of 4%, which is my prediction for 2011. We could easily get above that later in the year, but on a technical basis we might need to take a rest soon as nothing moves straight up.
Below is the yield on the 30 year bond, and we could move up into the 5% yield zone, but again, it's at those levels where we could see a rest in advancing yields.
Higher rates and lower bond values bring a host of potential issues not factored into the world: A "PUT" on the U.S. Government! Many of the associated issues with continually higher yields and lower bond values are not priced into the economy. It will be interesting to see if Bernanke under price stability will begin to focus on the bond market because a destabilizing move in the bond market could impact the economy.
Hope all is well.
J.D. Rosendahl, Rosey