Bond Investors See One More Run in Treasury

Overview:

January selloff in Treasurys presented buying opportunity ahead of U.S. budget debate
This may be the last definitive rally in Treasurys before yields start to rise
Bond managers, traders see 10-year yields slipping to 1.8% in near term

By Cynthia Lin

The U.S. Treasury market’s heyday of soaring prices is likely over, but some bond managers say there could be one more run.

Treasurys have soared since 2008, dragging yields to an all-time low of 1.4% from above 4%, in the wake of a financial crisis that resulted in the Federal Reserve buying trillions of dollars in Treasurys to help prop up the economy. But with the economy showing signs of life, a pullback in the central bank’s bond purchases that would mark the end of the bull run is now in discussion.

Until the Fed stops purchasing, bond investors say Treasurys have room for some short-term rallies. In the near term, an impending debate over U.S. government spending could be the trigger.

“We’re not all out of the woods yet,” said Matt Duch, who manages the government fund and bond portfolio at Calvert Investments. “We don’t love these Treasury levels, but it’s a good place to reassess.”

U.S. Treasurys fell 1% last month as investors felt optimistic about the economy, leading 10-year yields as high as 2.06%, from 1.75% at the start of the year. Bond yields rise when prices fall.

But the scope of the decline paled in comparison to the riskier stock market, where the Standard & Poor’s 500 index rose 5%. Mr. Dutch said he doesn’t believe the stock run was based on real progress in the economy, therefore he recently took money out of stocks and other riskier assets, and bought Treasurys when 10-year yields rose to 2%. He sees the yield trading as low as 1.85% in the near term.

The 10-year note yielded 2.02% late-Friday, according to Tradeweb.

Mr. Dutch and others see a potential turnaround in Treasurys in the near term, thanks to the impending U.S. government-spending debate. The stage is set for another heated debate in Washington as $85 billion of cuts in federal spending take effect March 1 unless lawmakers agree on a different deal to balance the budget.

Senate Democrats on Thursday proposed a plan to delay cuts on defense spending for a year, but still lower the national deficit through an equal mix of other spending reductions and higher tax revenues. Analysts don’t expect the plan to advance given the standoff over taxes.

Some investors say the run-up in Treasury yields ahead of this debate presents a perfect buying opportunity.

“The debate will reduce business confidence, and higher taxes are already dragging on consumers,” said Gary Pollack, head of fixed income trading and research at Deutsche Private Wealth Management. He sees 10-year yields falling as low as 1.8% in the coming months.

Even so, another record-setting rally in Treasurys is unlikely, say investors, who are largely calling for a 1.8% 10-year yield. That yield represents a far milder rally than the 1.4% yield some forecast just last fall.

Moreover, gains have been hard to come by even on days when economic reports fall short of expectations or the euro-zone debt crisis rears its head.

Barring an unexpected fallout in the euro-zone debt crisis or major setback to the U.S. economy, bond managers suspect any fear-driven rally next month to be one of the last legs of the Treasury market’s more-than-three-decade run.

“Yields will fall a little before we get higher,” said Michael Kastner, principal at Halyard Asset Management, who also points to a 1.8% on 10-year notes in the near term.

Mr. Kastner said the economy will have enough momentum to survive the government spending cuts, which will compel the Fed to start reducing its bond purchases and set the stage for a persistent rise in yields.