Bond Wars II: Revenge of the Conundrum

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Bond Wars II: Revenge of the Conundrum

Treasury yields are back down at levels that Greenspan called a 'conundrum.' Will they fall further?

May 26, 2005: 2:09 PM EDT
By Paul R. La Monica, CNN/Money senior writer

NEW YORK (CNN/Money) – The economy doesn't appear to be on the precipice of a major slowdown as many had feared just a month ago.

First-quarter economic growth was revised up to a 3.5 percent annual rate Thursday from the government's initial reading of 3.1 percent, which had been the slowest pace in two years. And even though consensus forecasts were for the government to revise growth up to a 3.6 percent annual rate, the revision helped alleviate fears that the economy was in a soft patch.

But don't tell that to the bond market. The yield on the 10-year U.S. Treasury stands at 4.07 percent, below where it was when the first government's initial reading on gross domestic product (GDP) came out on April 28.

Lower bond yields are usually associated with a weaker economy, especially when short-term interest rates have been rising. And the Federal Reserve has boosted short-term rates eight times since last June, bringing the federal funds rate, an overnight bank lending rate, to 3 percent from 1 percent.

So is the "conundrum" that Fed chairman Alan Greenspan famously spoke of during testimony to Congress in February back?

The case for a bond sell-off
Greenspan used that term to in wondering why long-term bond market rates were relatively low despite the rise in short-term rates over the past year. At the time, the yield on the 10-year was hovering at about 4.10 percent.

Greenspan's comments helped fuel weakness the bond market for a month or so, which pushed the yield on the 10-year Treasury as high as 4.69 percent at one point on March 23. Bond prices and yields move in opposite directions.

But since then, bond prices have rallied on signs the economy was weakening, which made sense when reports were pointing to a further slowdown in growth. But now, with more and more signs pointing to a rebound after a "soft patch" in March, long-term yields as low as they are have some investors scratching their heads.

"We're having a hard time making sense of where long-term rates are," said one fixed-income fund manager. "So much cash has been chasing the market ... I'm really worried that when it turns, everyone may run at the same time."

Translation: There could be a huge sell-off in Treasury bonds if more reports point to a significant pickup in GDP growth.

In fact, some analysts and investors believe that fears of a bond market sell-off are what prompted Greenspan to issue his conundrum comment in the first place.

Just as Greenspan warned investors of "irrational exuberance" in stocks in late 1996, he may be trying to signal to investors now that they shouldn't keep chasing the Treasury bond rally.

It's hard to pinpoint when exactly a shift in sentiment could take place.

No doubt bond investors will be watching the May job report very closely. Economists are predicting that 180,000 jobs were added during the month, down from a surprisingly strong 274,000 in April. The numbers are due May 3.

April's payroll number came in well above economists' forecasts, a sign corporations may finally be stepping up the pace of hiring. And while strong job growth is a plus, early signs of accelerating wage growth will make the Fed even more vigilant about inflation.

So another strong payroll number could finally convince bond investors that the Fed won't stop raising rates any time soon -- and spark a bond market sell-off that would push yields on the 10-year Treasury higher. The Fed cuts rates to spur economic growth and raises rates to prevent inflation

"The bond market has been focused on looking for nuggets of weakness," said Bill Davison, managing director of fixed income for Hartford Investment Management and manager of the Hartford Income fund. "But the payroll number could tip things the other way. Another strong number could start to change people's minds."

Some slowdown fears still linger
But not everyone is so sanguine about the second half of the year. Michael Cheah, manager of the SunAmerica GNMA and SunAmerica U.S. Government Securities fixed-income mutual funds, said he expects growth to slow sharply as the economy begins to feel the effects of the Fed's short-term rate hikes so far.

Another cause for concern, he said, is that the difference between short- and long-term rates is minimal -- a phenomenon known as a flattening yield curve.

"The yield curve is flat and typically when that happens, banks are reluctant to lend money and the economy becomes vulnerable," Cheah said.

As such, he thinks that the bond market's concerns of a slowdown are warranted and that yields on the 10-year Treasury could fall as low as 3.75 percent over the next three months or so.

In addition, Cheah said, Treasuries still are benefiting from a "flight to safety" since the corporate bond market's come under pressure after two big rating agencies cut General Motors (Research) debt to junk.