Time to bail on bonds
Yields on the benchmark 10-Year Treasury are approaching 4%. Here's why they'll hit that level soon and keep climbing.
 |
| Long-term bond yields fell as the Fed slashed interest rates to deal with the credit crunch. But with the market now focusing on inflation, yields are edging back towards 4%. |
NEW YORK (CNNMoney.com) -- Long-term bond yields are edging close to 4%, a level they haven't touched since the end of last year. And some experts believe yields will only head higher in the coming months.
Bonds have sold off in the past few days, pushing yields on the benchmark 10-Year U.S. Treasury note higher, to about 3.9%. Bond yields and prices move in opposite directions.
The rise in bond yields is significant for several reasons.
For one, it's yet another sign that Wall Street is now worrying more about surging commodity prices and a weak dollar than a recession, weakness in housing and the credit crunch. Long-term yields tend to fall during economic slowdowns.
"One of the things driving yields higher is the fear of inflation. We have a weak dollar and you see that with gas and food prices," said Brian Battle, vice president with Performance Trust Capital Partners, a Chicago-based investment firm.
In addition, since mortgage rates and the rates for other longer-term loans tend to move in tandem with the 10-Year, a continued rise in Treasury yields should lead to higher mortgage rates.
So how much higher will bond yields go in the near-term? Battle said that he doesn't think a 4.5% yield on the 10-Year is out of the question.
He said that another factor that may drive yields higher is the expectation that the government may have to sell more bonds to compensate for lower tax revenue that is likely to result from the economic slump.
"Supply fears are an issue. We may have bigger deficits because of economic weakness. With lower tax revenue, more bonds being issued and higher inflation, yields will have to go higher to attract buyers," he said.
What's this all mean for the markets and economy? If rates keep heading higher, the Fed may finally get the hint from the bond market that it needs to worry more about inflation and less about recession.
"Growth prospects going forward aren't as dire as we might have thought a few months ago at the height of the financial crisis," said John Hendricks, senior vice president with Hartford Investment Management Co. "There has been no evidence lately to suggest the economy is going to fall off a cliff."
As I pointed out in yesterday's column, traders are starting to believe that the Fed's next move may be to raise rates and that the central bank might do so as soon as its October meeting.
"The bond market is hopeful the Fed has handled the recession fears and that they now won't devalue the dollar even more," Battle said.
It is also is worth noting that at the same time bond yields have been climbing, stocks have been steadily moving higher as well. So this could be a sign that the market's appetite for risk is increasing as investors flee "safe" assets like Treasurys for stocks, which tend to offer greater rewards.
What's more, with consumer prices up around 3.9% year-over-year, there's less reason to own bonds since the real yield (after subtracting inflation) is close to zero.
"The flight to quality to Treasurys has dissipated," said Hendricks. "Why do you want to hold a Ten-Year note yielding 3.9% when inflation is around 4%? Yields have to go to 4% if not higher in the next couple of months."
Issue #1 - America's Money: All this week at noon ET, CNN explains how the weakening economy affects you. Full coverage.
Are you buried under a pile of debt and need help getting out? Did you recently manage to pull yourself out of debt and want to share your story? Tell us about your experience with debt and how the current credit crisis is affecting you.. Send us your photos and videos, or email us to share your story. 
