By Colin Barr
September 3, 2010

Is the flight to government bonds about to take a U-turn?

Worries about an economic relapse have sent government bond prices soaring this summer. The yield on the 10-year Treasury note fell as low as 2.47% last month from 3% at the end of July, as investors shunned stocks for safer-looking investments.

With practically every day bringing more dim economic news, the urge to flee for safe ground is undeniable. Yet some observers say the one-way bet on lower Treasury yields is no sure thing.

They say traders returning from the Hamptons after Labor Day will see an economy that is stubbornly weak, but not as deeply wounded as the Treasury markets might suggest.

“I’m really surprised people are committing capital at these levels,” said Bill Larkin, a bond manager at Cabot Money Management in Salem, Mass. “In terms of a lending arrangement, it doesn’t make sense for investors to be committing funds for 10 years at 2.6%.”

That’s not to predict a wholesale flight from government bonds. Bonds should continue to hold some appeal in an economy that at best looks headed for more weak growth and a long spell painfully high unemployment.

And with the Federal Reserve holding short-term rates close to zero for the foreseeable future, a market gut check this fall needn’t mean a bloody rout.

But the case for Treasurys at current prices assumes a strong probability of deflation, a persistent decline in prices that damages the economy by increasing real debt burdens. Every piece of economic news that shows even minor improvement undermines that case and boosts the argument that bond yields should be higher.

“The biggest risk to the bond market now is a recovery,” said Larkin. “If the economy is going in the right direction, even slowly, you can’t bet against that.”

There are signs the economy is growing, if barely. Though house prices appear poised to resume their decline and banks remain reluctant to lend, some indicators are pointing slightly up.

Unemployment is still high, but this recovery is actually adding jobs faster than previous ones. Manufacturing is not about to set any records, but it has held up better than Wall Street expected. Rail traffic is rising, and consumers are spending less but not weeping uncontrollably.

[cnnmoney-video vid=/video/news/2010/08/27/n_ss_lake_panel.cnnmoney/]

Andrew Barber, a strategist at Waverly Advisors in Corning, N.Y., said his firm has been betting on a decline in prices for the 10-year Treasury note since last week, in part on the assumption that the decline in yields has simply gone too far.

Barber isn’t urging everyone to short Treasurys, as some sages famously did this year not long before the biggest bond rally in years. Indeed, he admits that he has “no grand strategic view” now beyond a sense that a turning point might be at hand.

Needless to say, that turning point may take some time to arrive. But even if a big bond selloff isn’t at hand,  coming weeks are likely to bring enough frantic trading and big price swings that it will be hard at times to tell the difference.

While Barber remains skeptical about the prospects for a solid economic recovery, he says that unless bonds start paying better rates, many investors will find themselves holding their nose and heading into another venue that has been dogged by bubble chatter – the stock market.

“We continue to see plenty of reason for equities to continue to appreciate in the coming months, even though we remain skeptical that either the real fundamentals or the broad economy justifies it,” Barber said in a recent note to clients. “As one reader put it, we are increasingly casting ourselves as equity ‘anti-bulls’: bears with a long bias.”

You May Like

EDIT POST