Bond Investors Go to War with the Fed

NEW YORK ( -- Has the long-term Treasury bond bubble finally burst?

The yield on the 30-year Treasury rose above 4% Tuesday for the first time since August. The rate on the benchmark 10-year Treasury is now hovering just below 2.7%. That's a sharp increase from the 52-week low of 2.33% that the 10-year hit earlier this month.

Bond prices and rates move in opposite directions. So the recent spike in long-term yields is a sign of bond selling. That's interesting, especially since as the chart at the top shows, short-term rates have not moved up by nearly as much in the past few weeks.

With the entire free world expecting the Federal Reserve to unveil a new program of bond purchases at the conclusion of its two-day meeting on November 3, you might think investors would be unwilling to sell long-term bonds.

Many experts have been talking about how fixed-income investors should not fight the Fed. Why sell now when it's likely the Fed will be there as a buyer of last resort to keep rates low?

Influential bond fund manager Bill Gross of PIMCO wrote in his most recent outlook, published Wednesday, that bond yields should be on the rise after the Fed announcement. He thinks the Fed's next round of so-called quantitative easing, which many are dubbing QE2, should eventually lead to higher inflation.

"Check writing in the trillions is not a bondholder's friend; it is in fact inflationary," he wrote, adding that QE2 "will likely signify the end of a great 30-year bull market in bonds."

That's obviously a very bold statement. But it makes sense. It seems many investors have now more than priced in the notion that the Fed is going to spend upwards of $500 billion (and perhaps more than $1 trillion as Gross suggests) to keep rates low.

And investors apparently are making the leap that QE2 will work well enough to spark inflation. Perhaps too well.

"If you believe the inflation story, I wouldn't be buying Treasuries," said Vladimir Milev, a financial analyst with Payden & Rygel, a money manager in Los Angeles. "It's going to be a bad deal."

That also helps to explain how the Treasury Department was able to sell 5-year inflation-protected securities, or TIPs, at a negative yield earlier this week.

The market clearly isn't expecting inflation right now but the cumulative effect of the first round of quantitative easing and QE2 should add to pricing pressures significantly in the next few years. So buying a 5-year TIP -- even at a negative rate -- should lead to a healthy return as long as inflation eventually picks up.

Michael Strauss, chief economist with Commonfund, a money management firm based in Wilton, Conn., thinks inflation is on the horizon -- regardless of what the Fed does. That's because it appears the economy is slowly improving and a double-dip recession is far less likely.

Strauss is forecasting that the rate of inflation a year from now will run at about a 2% to 2.5% annual pace. If that's the case, the 10-year yield should be in range of 3.5% to 4%, he argues.

Still, some bond experts think short-term concerns about QE2 may resurface and that the recent bond sell-off could be nearing an end.

In a recent report, G. David MacEwen, chief investment officer of fixed income for American Century Investments in Kansas City, wrote that it's not as if the economy is going to suddenly spring back to life. What's more, even with quantitative easing, short-term rates are likely to remain near zero for a while.

"The Fed has reiterated its commitment to hold interest rates at record lows for the foreseeable future. It is precisely these conditions of stagnant growth, modest inflation, and low interest rates that we believe investors should prepare for going forward," MacEwen wrote.

Joe Balestrino, fixed income strategist at Federated Investors in Pittsburgh, added that it's difficult to imagine how investors won't be disappointed by the Fed next week since there is so much hype about QE2.

Along those lines, stocks took a tumble on Wednesday due to several reports indicating that the Fed may not announce as bold a plan to purchase more bonds as once thought. Balestrino said that could lead to more bond buying again in the coming week.

"I think long-term rates will fall after the Fed announcement. They are close to peaking," he said. " I would buy long-term Treasuries at this point."

Balestrino added that the rush to conclude that QE2 will be a success -- before investors even really know just how big the program is -- is a reckless bet.

"It will be a while before we get tangible evidence that QE2 is working and given the lagging nature of inflation, it could be a scary long time," he said. "I am not in the camp that this is a bond bubble."

But Strauss disagrees. He said that if the Fed does not announce some sort of major "shock and awe" type program, investors will quickly realize that there's once again a compelling reason to sell long-term Treasuries.

"Will the Fed continue to be a price insensitive buyer of Treasuries? Yes, but maybe not as big as we once thought," he said. "And if the Fed is not going to move quite as quickly, then why buy long bonds here?

- The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of, and Abbott Laboratories, La Monica does not own positions in any individual stocks.  

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