NEWS: ANALYSIS & COMMENTARY
Bonds:
Low yields could signal a bubble in the Treasury
market
On Sept. 4, the benchmark for long-term
There were other winners, too. People refinancing their
homes saved a bundle, since mortgage rates are tied to the 10-year note. And
corporate treasurers cheered because their borrowing costs are linked to
Treasury yields. From the booming housing market to business spending on new
equipment, the superlow yield on the mighty 10
"increases the chances of a strong economic recovery," says Martin J.
Mauro, Merrill Lynch & Co.'s manager of financial economics.
But in the week after Sept. 4, yields on 10-year notes edged
back above 4%, reaching 4.06% on Sept. 11. The rebound raises an uncomfortable
question: Is this the beginning of the end for extremely low Treasury
yields--and, conversely, high Treasury prices? In other words, is the Treasury
market a speculative bubble that's about to pop?
If there is a bubble and it's deflating, then sub-4% yields
on 10-year Treasuries could some day seem as out of whack as 5,000 on the Nasdaq Composite Index now appears. And pity new bond
investors if yields do jump; that means prices will fall. There are a lot of
such buyers out there: Morningstar says that in June and July alone, investors
yanked $71 billion out of stock funds and pumped $39 billion into government
bond funds.
Some investors may have switched from stocks to bonds in the
belief that since Treasuries are default-proof, you can't lose money on them.
But unless you hold them until they mature--which many individual investors
don't--you can lose money. Rising rates lower the resale value of old bonds,
because investors have the option of buying newer issues with higher coupon
payments. Predicts Mark MacQueen, a partner at bond
manager Sage Advisory Services Ltd. in
But if rising yields hold peril for bond investors, what
would they mean for the economy? That depends on why they're moving up. If they
rise because economic growth appears to be accelerating, the increase will be
harmless. It's normal for interest rates to rise when economic recovery
increases the demand for money. On that score, Standard & Poor's Chief
Economist David A. Wyss predicts that the economy
will grow 3.7% next year and 3.5% in 2004--and that the yield from the 10-year
note will drift up to 6% by the end of 2004.
But recovery could be hindered if yields jump abruptly for
other reasons. Among them: fears that inflation will rise, that Treasuries will
lose some appeal as a refuge, or that big deficits will create an oversupply of
10-year notes, which the government issues to raise money.
One factor that has been critical in keeping yields low has
been the market's confidence that inflation has been tamed, so that it won't
return even if the economy picks up speed. But even bond bull William H. Gross,
who runs Pacific Investment Management Co.'s bond portfolio, concedes that
there's at least a chance that inflation will accelerate. Says Gross: "If
we get...a return to 3%-to-4% inflation, which doesn't sound like much higher
than now but it is, then yeah, there's a bubble in bond prices, especially
Treasury prices."
Renewed investor confidence, while a good thing in its own
right, would also push up bond yields by decreasing the demand for
default-proof investments. Today, says Wyss of
S&P, "There's a flight to safety. People are more afraid of the
accountants than the terrorists right now." But he predicts the fears will
recede when the economy begins to gather steam.
What's more, investors may begin to worry that the Bush
Administration's budget deficits aren't just temporary. "Federal spending
programs, once they get started, are hard to stop," says Prudential
Securities Chief Economist Richard D. Rippe. "At
some point, the concern about the pressure those will put on Treasury financing
will intensify."
Yet another factor that has kept Treasury yields low is the
surge in mortgage refinancings. Holders of
mortgage-backed securities receive a wad of cash when homeowners refinance.
They often use the cash to buy 10-year notes. That pushes down the 10-year's
yield, which makes mortgages cheaper. If interest rates rise and refinancings slow, that will amplify a rebound in rates.
One bright spot is that if Treasury yields do rise,
corporate bond rates might rise less. That's because
corporate bond yields never fell as far as Treasury yields in the first place,
since they didn't benefit from the flight to quality and other special factors.
In fact, companies with BBB credit ratings are paying about 2.9 percentage
points more for 10-year bonds than the government is, vs. a 1.6 percentage
point gap in January, 2000, says Merrill Lynch.
Bubbles are hard to detect until they've popped, and bonds are no exception. But if Treasury yields do begin a long climb back up, investors who have already suffered from the stock market blowout will take another hit. And the economic recovery could be slowed as well.