Jittery investors bet slide in Treasury yields isn’t over

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We’re back to a familiar game in the U.S. Treasury bond market: How low can rates go?

As pessimism about the domestic economy has deepened in the last few weeks, the Treasury market has been the best indicator of that mood shift. The annualized yield on the 10-year T-note dived to 3.3% by the end of last week -- down from an eight-month high of 4% just a month earlier.

Traders were amazed by investors’ appetite for the $104 billion of two-, five- and seven-year T-notes the government auctioned the week of June 22, and for the $65 billion of three-, 10- and 30-year Treasuries sold last week. Now it looks those buyers made the right bets -- even though they know Uncle Sam has plenty more to sell this year.

‘All those ‘green shoots’ guys realize they were too optimistic’ about the economy, said Tom Tucci, head of Treasury trading at RBC Capital Markets in New York. ‘The reality of ‘lower for longer’ [on Treasury yields] has caught investors offside.’

Indeed, the big trade of the spring -- sell Treasuries, buy stocks -- has flip-flopped. While the Standard & Poor’s 500 stock index has fallen 7% since June 12, the iShares Barclays 20-plus-year Treasury Bond exchange-traded fund has risen 7% in the same period, to $96.23 a share as of Friday.

The dive in Treasury yields has been so abrupt that some bond market pros have been reluctant to recommend that clients jump in at this point, fearful of whiplash if Wall Street gets a few days’ worth of upbeat economic reports.

But investors who believe there is no economic recovery on the horizon may be quite content with a 3.3% yield on a 10-year T-note -- if no recovery also means that the major threat is deflation, not inflation.

If the inflation rate is zero, the 3.3% ‘real’ return on a current T-note would be rich by historical standards. And it comes with a principal guarantee, if you can hold to maturity.

In the near term -- the next week or so -- the Treasury market could just be powered by its own momentum. If the stock market worsens, institutional money exiting equities could pour into government bonds, pushing yields even lower. A rally to 3% would just return the 10-year T-note to its level of last winter.

The first leg of the latest bond rally ‘was just a reality check,’ said George Goncalves, fixed-income rate strategist at brokerage Cantor Fitzgerald in New York. If stocks keep sliding that could be the ‘death knell’ for risk-taking, further boosting Treasuries’ appeal, he said.

But then, don’t underestimate the resolve of the Obama administration and the Federal Reserve to do whatever it takes to keep Wall Street believing in a recovery. Treasury Secretary Timothy F. Geithner says there’s no point in talking about a second economic-stimulus program so soon -- but that could change in a heartbeat.

-- Tom Petruno