In a Turnaround, Slowing Economy Spurs Bond Rally - WSJ.com

In a Turnaround, Slowing Economy Spurs Bond Rally - WSJ.com


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In a Turnaround,Slowing EconomySpurs Bond Rally
As Inflation Fears Recede,Yields on Treasurys Decline;Housing's 'Hard Landing'
By MICHAEL HUDSONSeptember 26, 2006; Page A1
In one of the bigger surprises in financial markets this year, a growing sense that the economy is slowing and inflation receding is fueling a rally in the nation's bond markets, pushing Treasury-bond yields to their lowest levels in months.
The rally -- which started 10 weeks ago and has gained momentum in the past few days -- may help to shape the outlook for both the economy and for investments in coming months. Some doubt the rally will last, but if it does, lower interest rates could help buoy stock prices, make it easier for investors to make potentially risky bets with borrowed money, and ultimately help soften the blow from a weaker economy and a cooling housing market.
Because bonds pay fixed interest, their yields go down as investors bid up their prices, and vice versa. Earlier this year, Treasury yields rose as investors fretted that a strong economy would pump up inflation. Inflation eats away at bond returns, so investors dumped Treasurys, which pushed bond prices lower and their yields higher.
Now, in the upside-down world of bond investing, bad news about the economy has investors turning back to bonds, which is pushing yields back down, essentially making it cheaper to borrow money.
In June, a Wall Street Journal survey of 56 private economists showed that all but 13 expected bond yields to finish the year above 5%. Late yesterday afternoon, however, the yield on the 10-year Treasury note hit 4.55%, its lowest level since February and a large drop from 5.25% in late June.
"Looks like I'm wrong again today, right?" said Morgan Stanley economist Richard Berner. "I think the extent of this rally has caught a lot of people by surprise."
Yesterday's yield on the 10-year Treasury note was lower than the 4.65% yield on two-year Treasury notes and lower still than the 4.89% yield on three-month Treasury bills, something that is highly unusual, because investors typically demand higher returns for holding securities with longer maturities. The rate on overnight bank loans, which is driven by the Federal Reserve, is even higher -- at 5.25%.
Because the disparity between these rates is unusually large, some investors say something has to give -- either the Fed will begin cutting short-term rates in response to a weakening economy and low inflation, or the economy will start showing its strength and yields will turn higher.
For now, as the nation's once-hot housing market cools and the economic outlook dims, investors are coming to the conclusion that inflation isn't a worry, and they are gobbling up Treasury notes and bonds, pushing their yield lower.
The latest dose of bad news on housing came from the National Association of Realtors, which said yesterday that sales of existing homes dropped for the fifth straight month in August and that the median price of all homes sold last month declined 1.7% from a year earlier, the first year-to-year decline in more than 11 years.
"People are searching for safety," said Mark Kiesel, a corporate-bond portfolio manager at Pacific Investment Management Co., or Pimco. "I think the story of this [past three months] has basically been the hard landing in housing. That's become apparent to investors, and led to a rally in the bond market as people have realized slow growth is very likely."
The rally's impact could be significant. Perhaps most important, by helping to lower mortgage costs, the decline in bond yields could help buoy home sales and prices at a time when they are under growing downward pressure. The 10-year Treasury note is a benchmark for long-term mortgage rates.
Recent data from the Mortgage Bankers Association suggests that some families have taken advantage of a decline in long-term mortgage rates to refinance their mortgages and lock in lower payments. The association's index of mortgage refinancing applications has risen 27% since mid-July, and now stands at its highest level since February.
Lower long-term interest rates also send a potentially powerful signal to Federal Reserve policy makers that the bond market's inflation concerns remain contained, which could give Fed Chairman Ben Bernanke leverage to hold short-term interest rates steady in the months ahead, or possibly even reduce them.
The beginnings of the bond market's rally can be traced back to Mr. Bernanke's testimony before Congress on July 19, when he predicted that economic growth and inflation would cool.
Bond prices rallied that day and continued rising, with a few exceptions, as a series of economic reports verified Mr. Bernanke's assessments. "He kind of set things up there in July, and they played out exactly as he set them up," said Roger Bayston, a bond fund manager at Franklin Templeton Investments. "I think that solidified his credibility."
On Aug. 8, Fed officials decided to keep their target for short-term interest rates at 5.25%, breaking a string of 17 straight rate increases dating back to 2004. They held pat again on Sept. 20.
Many market watchers believe the Fed is unlikely to raise rates again this year, and is likely to begin cutting rates next year. That's a contrast to this spring, when they predicted a continued drumbeat of inflation-fighting moves by the Fed.
Investors and Fed officials have puzzled before over the extraordinarily low level of long-term interest rates. Former Fed Chairman Alan Greenspan called them a "conundrum." Typically, rates rise when the economy recovers from bad times, as it has in recent years. Long-term rates also tend to rise when the Fed pushes up short-term rates, as it started to do in 2004, when Mr. Greenspan still ran the Fed.
The low rates that date back to his stewardship have led to an increase in bond issuance by U.S. companies and have helped to fuel a boom in leveraged buyouts by private-equity firms, trends that the current bond rally could intensify, if it lasts.
Data collected by Thomson Financial shows that U.S. companies issued $68 billion in investment-grade bonds in August, a record for the month, as low default rates and flush corporate balance sheets have emboldened both bond issuers and buyers. Pimco's Mr. Kiesel said the slowing economy has yet to breed significant worries that defaults will increase, something that is keeping corporate borrowing costs low.
The housing slowdown isn't the only factor in the bond rally. Falling oil prices have strengthened the view that inflation is contained. Meanwhile, investors tend to flock to Treasury bonds when they worry about risks in other investments. Political turmoil in places like Thailand, Russia and Hungary might be heightening the concerns of some. So might the recent collapse of Amaranth Advisors, a hedge fund that lost billions on bad natural-gas bets.
Morgan Stanley's Mr. Berner noted that, in the near term, interest-rate declines tend to feed upon themselves. That's partly because of a connection between the bond and mortgage markets. Lower rates make homeowners more likely to refinance mortgages, meaning they are keeping their mortgages for a shorter period. These shorter maturities force some investors and big mortgage holders like Fannie Mae and Freddie Mac to adjust their hedging strategies by buying long-dated Treasurys, which puts more downward pressure on bond yields.
As Treasury yields drop, he said, the process can be at least temporarily self-sustaining, because the lower Treasury yields go, the more mortgage-bond investors will put their money into Treasurys, thus driving the government bond yields even lower.
Many economists and traders say the downward march of bond yields can be sustained only if the Fed starts cutting interest rates early next year. But some doubt that will happen. Bear Stearns Cos. economist John Ryding argues that housing worries have been overstated and that the broader economy is on solid footing. Retailers, for instance, appear to have posted healthy sales so far in September.
Mr. Ryding argues that the bond surge is less about economic fundamentals and more of a "technical rally" powered by a shift in momentum sparked by the Fed's July pause in raising interest rates. "These current yields can't hold without a Fed cut," Mr. Ryding said. "I think the rally will fizzle out at some point here."
Write to Michael Hudson at michael.hudson@wsj.com1