December 23, 2010 / 5:30 PM / 8 years ago

Analysis: Bond market braces for higher yields in 2011

NEW YORK (Reuters) - Wall Street expects higher Treasury yields next year, and one primary dealer has the 30-year bond hitting 6 percent for the first time since 2000.

But investors will have to be nimble, since variables such as the pace of U.S. growth, high U.S. deficits and Europe’s lingering debt crisis probably means that any rise in yields proceeds in a zig-zag pattern rather than a straight line.

Yields, which move inversely to the price of bonds, slumped for much of 2010 as fears that the United States would slip back into recession drove a safety bid for bonds, but yields recovered as economic data improved.

A deal in December to extend U.S. tax cuts and temporarily cut the payroll tax drove 10-year yields to a seven-month peak near 3.57 percent and left Wall Street betting that 2010’s halting recovery would blossom into self-sustaining, if not overwhelming, economic growth in 2011.

“My expectation after the fiscal stimulus from the payroll tax holiday is the ranges of yields are just naturally going to be higher” next year, said Michael Mata, who manages assets worth $600 million for the ING Global Bond Fund in Atlanta.

A 3 percent to 3.20 percent range should be a floor for benchmark 10-year yields, he said, “and 3.75 percent to 4 percent will be touched sometime in the first half of next year.”

That would take yields back to levels seen in early 2010, when the 10-year peaked at 4.01 percent before plunging on fear of a double-dip U.S. recession and Europe’s debt woes. The 10-year yielded 3.36 percent on Thursday, about 100 basis points above its 2010 low.

A recent Reuters poll of primary dealers had a median 2011 growth forecast of 3.05 percent, up from 2.7 percent in early December. Goldman Sachs expects the economy to expand at a 3.4 percent rate.

Analysts said that trend will draw investors toward equities, commodities and inflation-linked securities and reverse the massive inflows into bond mutual funds seen in 2010.

Domestic investors have yanked some $2 trillion out of zero-rate money market funds over the past 20 months, according to iMoneynet data, with much of it landing in bond funds.

Mata said much of that money will now find its way into equity funds in 2011. “It won’t be a tidal wave out of Treasuries, but this year the flows were just tremendous.”

In what could be a preview of things to come, Investment Company Institute data showed investors pulled $8.6 billion from U.S.-listed fixed income funds in the week to December 15, the biggest weekly outflow in more than two years.

SHUNNING SOVEREIGNS

Another force that could undermine Treasuries is a growing distaste for sovereign debt, particularly that issued by developed countries with high deficits and subpar growth.

Citigroup’s chief economist said this year that Europe’s debt turmoil may be the “opening act” of a debt crisis that could even infect the United States.

While not in straits as dire as Ireland or Greece, the United States does run a budget deficit above $1 trillion, one of the largest peacetime shortfalls in its history. The tax cut deal could swell it further, as it will require Treasury to issue still more supply to offset a shortfall in tax revenues.

Guy LeBas, chief fixed income strategist at Janney Capital Markets, said the U.S. tax cut deal “not only (adds) to 2011 and 2012 supply but it’s convincing markets that supply will be elevated above expectations for years into the future.”

The Federal Reserve, of course, has been a major source of Treasury demand, and a pledge to buy $600 billion worth by the middle of 2011 in an effort to boost the economy will soak up some of that supply. But analysts fear that can’t go on forever, particularly if U.S. growth starts to stoke inflation.

“The market understands that while the Fed is buying more now, it will have to sell later,” said Ward McCarthy, chief financial economist at Jefferies & Co’s fixed-income division.

Other buyers, including foreign central banks, the other pillar of Treasury demand, may require higher yields to step in. In fact, central banks’ Treasury demand has started to level off recently after rising sharply in 2009 and early 2010, according to Treasury Department data.

Jefferies expects these pressures to help push the 10-year yield to 5 percent in 2011 and the 30-year yield to 6 percent, a level it hasn’t seen since 2000.

AN ALTERNATIVE SCENARIO

Analysts warn, however, that a number of short-term risks could complicate matters. If Europe’s debt crisis spreads from Ireland to Spain and beyond, U.S. yields would likely fall on a safe-haven bid, much as they did in early 2010.

Likewise, if inflation forces China to tighten monetary policy sharply, that could slow global growth and the U.S. economy.

“Our 2011 base case,” Morgan Stanley Smith Barney’s investment committee said in its annual outlook, “is for yields to follow a volatile, saw-toothed ascending pattern.”

For some, though, the problem with a higher yield forecast is a simple one: with unemployment at 9.8 percent and the housing market still fragile, the U.S. economy simply can’t sustain much higher long-term interest rates.

“It’s not that the economy isn’t getting better — it is,” Deutsche Bank strategists wrote in a note to clients. “Instead it is that there are so many headwinds to work through that recovery is not consistent with premature monetary tightening, either by the Fed or the markets.”

They add they expect Treasuries to rally in 2011 and “once again disappoint the economy optimists.”

Robert Tipp, chief strategist at Prudential Fixed Income, said even with a growth rate above 3 percent next year, “we’d be lucky to see unemployment drop below 9 percent.

“We’ve had a big upswing on optimism on the economy but the fact remains that inflation is likely to stay low and the Fed is likely to keep interest rates near zero for some time,” he added. “There’s a good chance that a year from now, rates will not be a lot higher than they are right now.”

Reporting by Ellen Freilich, Karen Brettell and Steven C. Johnson of Reuters and IFR Global Rates Managing Analyst Kenneth Logan; Writing by Steven C. Johnson; editing by Leslie Adler

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