Fear and loathing in the bond market

NEW YORK (CNNMoney.com) -- So much for those worries about rising long-term interest rates.

Remember when people were concerned that the end of the Fed's so-called quantitative easing program, the propping up of the fixed-income and mortgage markets, would lead to a big sell-off in Treasury bonds and spike in yields?

• Email
• Print
• Comment

Those fears have quickly disappeared as investors fret more about the debt crisis in Europe. People have flocked back to U.S. Treasurys since they are still perceived as a safer bet than anything tied to the incredible shrinking euro.

The yield on the U.S. 10-year Treasury, which was around 3.8% as recently as late April and thought to be heading to 4% before long, is now about 3.32%. (Bond prices and yields move in opposite directions.)

So what's next? Experts said that Treasury yields may continue to fall as long as the problems in Europe persist and the euro weakens further.

"This is kind of a reenactment of the Armageddon trade," said Doug Roberts, chief investment strategist for ChannelCapitalResearch.com in Shrewsbury, N.J., referring to the mad rush into Treasurys in late 2008 following the collapse of Lehman Brothers.

That panic pushed 10-year yields all the way down to nearly 2%. Roberts said he doubted rates will fall that low again but did not rule out the likelihood of the 10-year yield inching closer to 3% if Europe's debt problems spiral further out of control.

While that may be good news for anyone looking to buy a house since mortgage rates may remain relatively low, it could be yet another sign of just how shaky the global economy is right now and how nervous investors are.

Brian Battle, vice president with Performance Trust Capital Partners. a fixed-income trading firm in Chicago, said it would not be a surprise if the 10-year hit 3.25% soon. It came close to that level on May 6 -- the day of the "flash crash" -- before recovering a bit.

It's clear that there is still significant demand for Treasurys now. According to the most recently available figures from the Treasury Department about foreign holders of U.S. debt, China increased its stake in U.S. Treasurys as of the end of March.

Battle said it's very likely China boosted its position again in April. (Those numbers will be released in mid-June.) But he said it's important for people to realize that many investors are buying Treasurys as a last resort -- not as an endorsement of the economic health of the U.S.

"China and others are buying Treasurys because they are denominated in U.S. dollars. It's not because people love the U.S. government or its fiscal policies," he said.

Mike O'Rourke, chief market strategist with BTIG, an institutional brokerage firm in New York, agreed.

"A fundamental shift has occurred throughout this crisis. Over the past five years, the euro had come to be viewed as a reserve currency, equivalent to the dollar. That's no longer the case. So anytime there's a flight to quality, it's going to mean a rush into U.S. bonds," he said.

Still, one expert said that the drop in long-term rates is not just about Europe. John Stoltzfus, senior market strategist with Ticonderoga Securities, an institutional trading firm in New York, pointed out that the most recent data on wholesale and consumer prices show no signs of inflation.

With that in mind, he said long-term rates probably should hover around 3.5% for the time being. He added that the Federal Reserve has ample reason to keep short-term rates near zero for the foreseeable future as well.

While that may raise the risk of a nasty inflation shock down the road if the Fed is too slow to boost rates once the economy really has recovered, Stoltzfus said containing Europe's problems now is a greater priority than worries about inflation in a few years.

"Low long-term rates endorse the Fed policy of keeping short-term rates on hold for a longer period of time. That's more important at a time when the markets are so turbulent," he said.

Christopher Molumphy, chief investment officer of fixed income with Franklin Templeton in San Mateo, Calif., also said that long-term rates should remain below 4% for a while since inflation is benign.

But he warned that unless the U.S. takes steps to cut spending, investors may one day sour on our debt too. "Longer-term, we do remain concerned about Treasurys," he said. "Ultimately, the U.S. will have to exhibit more fiscal discipline. Otherwise that will come home to roost."

- The opinions expressed in this commentary are solely those of Paul R. La Monica.