Treasury yields fall as bears capitulate

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NEW YORK (CNNMoney) -- There are economic clouds on the horizon, and that's giving investors an appetite for U.S. Treasuries in case a storm breaks.

After falling below the key psychological level of 3% for the first time in five months Wednesday, the yield on the benchmark 10-year Treasury note edged up Thursday to 2.99% from 2.97% in the prior session.

Treasury yields have been falling since early April as prices have rallied on growing demand for safe alternatives to stocks and other risky assets.

The so-called flight to quality comes in response to signs of a slowing economy. While many economists still expect growth to pick up later in the year, investors are bracing for a sluggish summer.

Just this week, reports on the job market and manufacturing activity showed weakness. And the number of Americans filing initial unemployment claims remains elevated.

That bodes ill for Friday's payrolls report from the Labor Department. Economists surveyed by CNNMoney say they're expecting to see that 170,000 jobs were created in May, and that the unemployment rate eased to 8.9% from 9% in April.

But investors aren't just worried about jobs. There is also the debt crisis in Europe, which has been festering for more than a year, and the end of the Federal Reserve's $600 billion Treasury buying spree known as QE2.

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All of these concerns prompted George Goncalves, a fixed-income analyst at Nomura Securities, to recommend buying more Treasuries nearly two months ago.

"Those arguments still remain in force today as the market has moved through successive stages of recognizing and pricing the full extent of these concerns," he wrote in a client note. "The final stages of this process, the proverbial 'throwing in the towel' by the most die-hard Treasury bears is what remains before yields can finally put in a bottom."

Goncalves said the 10-year yield is more likely to fall to 2.75% than rise to 3.25%, but he was wary of trying to time a bottom in the market.

Other analysts expect yields to fall even further.

John Higgins, an analyst at Capital Economics, said the 10-year yield could hit 2.5% by the end of the year.

The inflation outlook and monetary policy will be the primary drivers of long-term Treasury yields, he said.

The Fed is not expected to raise interest rates until 2012, according to Higgins. And the recent sell-off in the commodities market suggests that inflation will remain subdued, which would be a bond-friendly development.

"Of course, plenty of investors expect the end of QE2 itself to derail the Treasury market," he said. "However, we think the opposite is more likely."

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Higgins argues that the absence of QE2, which has been a big driver of stock prices, will push more investors into safe-havens like Treasuries.

In addition, he said bondholders are unlikely to be spooked by the standoff in Washington over the debt ceiling and that the government will eventually get its fiscal house in order.

"Congress seems to be waking up to the need for fiscal tightening, the implementation of which will retard growth and require monetary policy to stay loose for even longer," he said.