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Bonds: Boom or bust?
If the Fed keeps raising rates, long-term yields have to head higher too. Or do they?
June 24, 2005: 12:15 PM EDT
By Paul R. La Monica, CNN/Money senior writer
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NEW YORK (CNN/Money) - The Fed is probably going to keep raising interest rates throughout the summer. But will longer-term bond yields finally head higher as well?

Some economists say that the Fed would like to see long-term rates move higher in order to remove some of the froth in the housing market. Low Treasury yields have helped keep mortgage rates down and Fed chairman Alan Greenspan has expressed some concern in speeches about the rise in home prices.

In theory, more rate hikes should eventually force bond investors to realize that the economy is still in decent shape. Bonds would start to sell-off a bit as a result, which would push yields higher. (Bond prices and yields move in opposite directions).

As such, RBC Dain Rauscher chief economist Vincent Boberski and Chris Probyn, chief economist at State Street Global Advisors, both said that the yield on the 10-year could wind up at about 5 percent by year's end. The yield on the 10-year is currently below 4 percent.

"The higher that rates go from here, the more the bond market needs to respond to them," said Probyn. "The bond market should finally respond to upward pressure on long-term rates."

But others argue that if the Fed keeps raising rates, bond investors may take that as a sign that inflation will stay well controlled, and that there's a greater risk of an economic slowdown, which could send yields even lower.

John Derrick, director of research with U.S. Global Investors, and Brian Stine, investment strategist with Allegiant Asset Management, both think that yields on the 10-year could end the year at around 3.5 percent, which is about the same level they expect for the federal funds rate.

Typically, a narrow difference between long-term rates and short-term rates, known as a flat yield curve, points to trouble for the economy. And if short-term rates move above long-term rates, known as an inverted yield curve, that points to a recession.

Still, bond bulls argue that no matter what the Fed does, long-term yields could keep falling -- but that might not be a sign of doom and gloom. They say that healthy demand for Treasury bonds from foreign central banks and pension funds will keep bond prices rallying -- and yields low.

In addition, bond investors are likely to keep on seeking safer fixed-income investments such as Treasuries after some of the major bond-rating agencies cut the credit ratings of General Motors and Ford to "junk" status last month.

"Historically a flat or inverted yield curve is bad news for the market but I don't think that is the case this time," said Stine. "Buying of Treasuries won't go away when the Fed stops raising rates. The long-end going down just reflects demand for long-term bonds."

For more about next week's Fed meeting, click here.

For a look at bond rates, click here.  Top of page

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