Friday 27 May 2011

Slow burn" bond rally smoulders on


(Reuters) - Bond investors are slowly coming around to the idea that U.S. Treasury yields are not on a relentless drive higher.

Far from it, in fact, given that the 10-year yield may soon fall below 3 percent.

It's an epiphany that flies in the face of expectations, solidified earlier this year, that rates were headed higher as the economic recovery took hold, the Federal Reserve moved toward tighter monetary policy, and the government faced a potential budget crisis.

A weak run of economic data, however, has turned that notion on its head.

"Investors had really wrapped their minds around the fact that an economic recovery and the deficit fight were going to keep us in a high interest rate environment for some time," said Robert Tipp, chief investment strategist at Prudential Fixed Income in Newark, New Jersey, with $270 billion in assets under management.

"Every data point that refutes that view is bringing Treasury buyers back into the market reluctantly to cover their positions," he said.

Wall Street economists are now revising down their economic growth forecasts. Bank of America Merrill Lynch on Friday cut its second-quarter GDP growth forecast to 2 percent from 2.8 percent. Treasury analysts are predicting a "grind" to lower yields. Fed funds futures show expectations for the first rate hike from the Fed receding into 2012.

"Economic data has been somewhat consistently more downbeat of late and this has allowed for the recent slow grind -- or slow burn for the sold out bulls like me -- to lower rates," said William O'Donnell, U.S. government bond strategist at RBS Securities in Stamford, Connecticut.

There are, however, "solid bands of resistance" against a quick decline in 10-year yields, he said, created by "layers of sellers that we expected to see, and have seen, into this push toward 3 percent."

The resistance may give way if troubles in euro zone countries persist and if the U.S. Labor Department's report on job growth for May, due out next Friday, shows more weakness.

The downward move is far from certain. Jim Vogel, head of fixed income research at FTN Financial in Memphis, Tennessee, said while the 10-year yield could break below 3 percent, it could also head higher.

"Oil goes down and reduces concerns about inflation? Gasoline prices then go down and people can spend more, so the economy picks up and then rates might go up," he said, identifying a potential range in that case of between 2.90 percent and 3.35 percent for 10-year yields.

"What if the European Union doesn't come up with a solution for Greece? Well that probably takes us below 3 percent," he added.

"What if they do come up with a solution for Greece that doesn't involve a default and they kind of patch things up? Rates go back up to 3.30 percent."

Vogel said the battle in Congress over how to cut the budget deficit, which is currently tied to a standoff over raising the legal borrowing limit, would also factor in heavily.

An agreement involving a tax increase would send rates down, he said. But an agreement that would "balance the deficit in some kind of accounting terminology," but without a solution that pleases markets, would send rates back up to 3.30 percent.

In Tipp's view, those scenarios would add up to pretty much the same thing: Treasuries would continue in their post-recession range, with a 10-year yield of between 2 percent and 4 percent, which he said he expects to hold for the next several years.

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