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Bond Market Rally May Signal Dark Times to Come

Thursday, 02 Jun 2011 12:00 AM

 

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A torrent of terrible economic data has electrified the U.S. Treasury market, driving the key 10-year note's yield lower and prompting investors to predict a further plunge.

On Wednesday, the yield on the benchmark 10-year Treasury note fell below 3 percent, the first time since December, on further evidence the economic recovery is losing momentum — and fast.

That may be good news to investors who are long the Treasurys market, but for those who have money in stocks, commodities or other higher-risk assets, it could spell big trouble ahead.

Neither is it good news for the large number of unemployed people in the United States whose hopes of a jobs-creating recovery could be dashed.

"It does look like we have a pretty weak rebound, even weaker than we had considered," said Jason Brady, a managing director for Thornburg Investment Management in Santa Fe, New Mexico.

The 10-year Treasury bond is one of the most widely watched securities as it sets the benchmark for almost every other interest rate in the U.S. economy, from the cost of financing corporate debt and mortgages to credit card balances.

Many investors previously expected yields to rise — even spike — with the end of the Federal Reserve's latest bond buying program nearing and the economy experiencing a self-sustaining recovery.

But weakening employment and troubled housing markets, unresolved debt problems in Europe and Japan's struggle to recover from the earthquake have money managers reversing course.

Dan Fuss, vice chairman of $150 billion Loomis Sayles, said on Wednesday he isn't ruling out a 2.50 percent yield on the 10-year Treasury note -- 44 basis points lower than the current 2.94 percent at New York close on Wednesday.

"I emphasize that I give it low odds, but it is possible," Fuss said.
It was only on Feb. 9 that the 10-year's yield peaked at 3.78 percent.

Bret Barker, portfolio manager at $120 billion TCW in Los Angeles, said he too isn't ruling out 2.50 percent on the 10-year's yield, but sees a 2.75 percent yield as more plausible.

"We hit 2.50 percent when Lehman Brothers collapsed and just before QE2 began with fears of a double-dip recession and deflation," he said. "We assign a low probability to both deflation and a double dip."

The yield on the 10-year Treasury note hit an intraday low of 2.33 percent on Oct. 8, 2010, ahead of the Fed's second round of bond purchases, also known as Quantitative Easing 2.

But that doesn't compare to levels following Lehman's implosion when the 10-year yield intraday low was 2.04 percent on Dec. 18, 2008.
Sean Simko, senior portfolio manager at SEI Investments in Oaks, Pennsylvania which oversees $179 billion in assets, said Friday's non-farm payrolls report could extend the bond market's moves.

"If Friday's payroll number disappoints, we could have another leg down in yield. It could press below 2.90 percent."

U.S. nonfarm payrolls likely increased by 150,000 in May, according to a Reuters poll, less than the 180,000 forecast before a report on Wednesday showed a sharp slowdown in private job growth last month. For more details please click on

GROSS VERSUS GUNDLACH

The bond market's explosive rally has even caught the world's biggest bond manager off guard.

Since Bill Gross' $240 billion PIMCO Total Return fund took its initial "short" position in U.S. government-related debt in March, Treasury yields have slid roughly 45 basis points.

Gross is not short Treasurys, but swaps, according to a source familiar with the matter. Swaps are an agreement between two parties that receives a fixed rate of interest and pays a floating rate (three-month LIBOR).

When an investor "shorts" a swap, he agrees to pay a fixed rate in exchange for a floating rate, which is just the reverse. To put it simply, it's a bet yields will rise because the price of the swap will go down similar to a Treasury bond.

Gross' fund is up 3.38 percent so far this year, outperforming 52 percent of his peers, according to Lipper as of May 31 data.

Jeffrey Gundlach, chief executive of the $10 billion DoubleLine Capital, predicted in December that the U.S. economy would not be able to handle a 10-year Treasury rate rise above its then current level of 3.50 percent.

"The economy, society and government are fueled by debt," Gundlach said, and cannot run successfully in a rising interest-rate environment.

The chances yields could reach 2.5 percent do seem slim. It took extraordinary circumstances to get them far below 3 percent last time.

But in a marketplace where most asset classes are suggesting some mix of optimism, the bond market's signals suggest more caution is needed.

For now, Gundlach's fund is far outperforming Gross's. His DoubleLine Total Return, albeit in a different bond category to Total Return, is up 5.17 percent so far this year and beating 85 percent of its peers, according to Lipper as of May 31.

© 2014 Thomson/Reuters. All rights reserved.

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