Treasury bond party over?

November 3, 2004
By Andrew Stein, CNN/Money staff writer

NEW YORK (CNN/Money) - Concerns about oil prices and the presidential election attracted investors to the safe-haven of Treasuries recently. But with those factors cooling, yields may be set to run higher.

The yield on the 10-year note hovered below 4 percent late last month, but it has jumped above the 4.10 level as of Wednesday afternoon, following a quick resolution to the election with a victory by President Bush.

Another factor lifting yields has been a sharp slide in oil prices to below the $50 a barrel level following government reports in the past couple weeks showing a strong increase in the U.S. supplies of crude oil.

What happens in the Treasury market is important not just for bond investors. It affects the stock market and has a big impact on the economy, since Treasury yields affect many lending rates, including home mortgages.

Election tension
While uncertainty about the election and worries about a prolonged dispute over the outcome sent investors fleeing for the perceived safety of the Treasury market, that doubt set the stage for a quick reversal, according to Larry Kantor, global head of economics at Barclays Capital.

"The knee-jerk reaction is more about somebody winning, rather than who wins," he said. "If there's a clear winner, it will be good for equities and bad for bonds."

If there were a long legal fight about who won the Oval Office, it may have driven money out of stocks and out of the country, said Christopher Low, chief economist with FTN Financial.

"In a major crisis, like after 9/11, people take the flight to safety further and put some money into Europe," he said.

Oil hits its slide?
After making its way through the summer soft patch, the economy may be set to accelerate as oil prices have dropped more than 12 percent over the last week and oil has been a big influence on the bond market, said Matthew Martin, senior economist at Economy.com.

While the rebound from the soft patch has been about what Federal Reserve policy-makers have expected, Martin said, "what they're really looking at now is oil prices."

Traditionally, high oil prices have spooked bond investors, who are hypersensitive to anything that erodes their returns. But this year, rather than worrying about inflation, bond investors are betting that high oil prices will act as a drag on economic growth, which would tend to keep interest rates low. Thus, bonds have rallied despite rising oil prices, pushing Treasury yields lower.

"Energy input per dollar of GDP is about half of what it was 30 years ago," Martin said. "And with increased global trade and more competition, it means businesses can't push along prices to consumers, so it's less inflationary."

But yields began a gradual return to the 4 percent level as the economy hit its soft patch over the summer.

John Lonski, senior economist at Moody's Investor Service, believes bond yields will remain around current levels until hiring picks up again.

"The Fed will eventually move to a neutral stance, and I don't think we're there yet," said Lonski. "When we start to see payrolls of 200,000 a month, I expect the yield on the 10-year note will hit 4.5 percent and the Fed will become less patient."

Policy-makers at the Fed, which has been raising short-term rates from super-low levels, meet again in November and December and may feel they have more room to raise short-term rates twice more, though December rate hikes are less common, according to FTN's Low.

"In its last two tightening cycles in '94 and '99, the Fed didn't raise in December because it wanted to limit the impact on retailers before the holidays," he said. "This time, it's a tough call."

Barclays' Kantor added: "I don't know that even the Fed knows what it will do in December, but most people are sure they won't be done raising rates in November."

The central bank started raising rates in June to where they stand now, at 1.75 percent, after cutting them aggressively the prior three years.

Bond traders are pricing in about a 90 percent chance that the Fed will lift rates another quarter percentage point on Nov. 10, but they're betting on only a 35 percent chance of another increase when the central bank's policy-makers meet Dec. 14, according to Low.

Another thing the Fed will be watching is China, which took its boldest step yet to try to cool its red-hot economy by lifting interest rates for the first time in nine years. "This provides some conviction that China's economy is still growing very fast," said Milton Ezrati, senior economist with Lord Abbett.

And if China's torrid economic growth continues, it may drive inflation higher worldwide, which could give the Fed another reason to raise rates more aggressively.

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