three arrows

While March fears of an imminent bond market meltdown were premature, many investors are still wondering when it will be the beginning of the end of the 30-year bull market for Treasuries.

Assuming the recovery remains on pace, we believe that yields will back up modestly in 2012, probably to around the 3% level, and that a sustained bond market sell-off is unlikely in the near term. Factors — including economic data suggesting a slow recovery, investors’ continued aversion to risky assets and price insensitive government buyers — that have conspired to keep rates abnormally low for the past year are still in place.

But looking forward here are signs investors can watch for that may signal that a more dramatic back up in US Treasury rates could be at hand:

1.) A return to long-term trend growth. Investors should pay attention to three types of indicators — leading economic indicators such as the Chicago Fed National Activity Index (CFNAI), inflation expectations and demand for capital – for signs the economy is returning to its long-term growth trend. So far, only one of these indicators — demand for capital — is suggesting this may be the case.

While the household sector continues to reduce debt, companies have started to borrow again. As of the end of March, commercial and industrial loan demand was growing by 13% year over year, a 3 ½ year high. This is probably insufficient to push rates higher on its own, but it does provide evidence of some normalization in the capital market, at least for businesses.

In contrast, most leading indicators still continue to suggest an economy characterized by positive but weak growth, and both breakeven spreads in the TIPS market and consumer sentiment continue to show that inflation expectations remain relatively well anchored in the 2% to 2.5% range.

2.) A more sustained resumption in investor appetite for risk. A resumed investor preference for risky assets would suggest a quicker, or more dramatic, rise in yields. On this score, investors should continue to focus on Europe, particularly European bond yields and CDS spreads. As Europe is still the major source of global systematic risk, any sustained improvement in the outlook for Europe will likely improve investor sentiment. In fact, prior to last spring’s realization that Europe’s problems were far from solved, 10-year US Treasury yields were more than 1.5% above their current level.

3.) A marked deceleration in public sector purchases. To the extent aggressive bond buying by the Fed and other foreign official buyers continues – either through another round of quantitative easing or through more aggressive buying by the Chinese and Japanese – yields are likely to remain low. Investors should pay close attention to whether or not the Fed decides to extend its asset purchase program, and to how and when the Fed starts to sell the longer maturity bonds it holds. To assess how long foreign official sector entities such as China and Japan will buy US bonds, it’s useful to monitor monthly TIC Treasury flows and indirect bidder percentages at auctions.

By watching for the signs detailed above, investors can gain a sense for the likely timing of the long expected rise in interest rates. We’re reasonably certain the economy will eventually improve and investors will rediscover their appetite for risk. In addition, while it’s possible that the bond market will remain increasingly dominated by global institutions for a prolonged time, such a state of affairs would assume that macroeconomic conditions remain constant indefinitely, which is unlikely.

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