Queasy living for the bond market

December 13, 2010, 11:07 PM UTC

It’s time for bond investors to get used to that unsettled feeling.

Prices of U.S. government bonds were actually up modestly at midday Monday, which certainly looks like progress after last week’s plunge. The yield on the 10-year Treasury note was down a couple ticks at 3.28%, after a short-lived morning spike to 3.39%.

More of the same ahead?

But Monday’s rebound doesn’t say the carnage is done with. Investors who started banking on handsome bond returns during the long 2010 rally have seen prices pull back 5% or so from their peaks — wiping out more than a year of expected income. Flows from stock funds and into bonds have slowed and in some cases reversed.

What’s more, the fear driving last week’s selloff — that Congress and the White House are simply too craven to behave responsibly — has only grown stronger since last week’s tax deal.

Remarkably enough, that’s true even among those who believe an agreement to stimulate the economy was the proper course of action.

“Last week was kind of a seminal moment for the bond market,” said David Kelly, chief market strategist at J.P. Morgan Funds. “A stimulative policy is clearly the right course of action – but only if you are willing to make some tough decisions alongside it. We certainly aren’t seeing any evidence of that yet.”

Kelly said that without congressional action to slash spending and improve the fiscal outlook, the United States is looking at a fourth consecutive trillion-dollar-plus deficit in 2012 – even if the economy picks up the way our political enablers hope.

Just in August, the Congressional Budget Office was saying the deficit could slip back to $650 billion that year, which itself would not exactly win any medals if not for the ever declining standards of fiscal policymaking.

“This makes me long for the days of David Stockman talking about $200 billion deficits as far as the eye can see,” said Kelly.

The other question for bond investors is how the crisis in Europe will play out in the coming months. A bad outcome there, whether a funding crisis in a weaker European economy such as Portugal or Spain or a banking crisis driven by fears that whole swathes of the Continent are insolvent, could drive funds out of Europe and into the dollar, presumably sending Treasury yields tumbling again.

But in the absence of a total meltdown over there, Kelly said he believes real yields, adjusted for inflation, should grow along with the U.S. economy over time – which could mean an even more painful beating for those holding long-duration government bonds.

He said he believes inflation is unlikely to return to the United States any time soon, given high joblessness and extensive economic slack. But inflation expectations have been rising in recent months, albeit from extremely low levels, and if that continues along with the recovery, we could see a 10-year Treasury bond yielding 5% or even 6% in the coming years.

Don’t expect to see a financial crisis spurred by foreigners fleeing the dollar, “assuming we’re all adults about how we handle this,” Kelly said. “But investors should realize you’re risking losing money in bonds when you could be making money in stocks.”