Have U.S. Government Bonds Learned To Levitate?

(Bloomberg) -- Walt Rawley, the protagonist of Paul Auster's 1995 novel ``Mr. Vertigo,'' learns to levitate by achieving simultaneous ``loft and locomotion.'' U.S. government bonds appear to be performing the same unlikely stunt.
Investors continue to pour money into the fixed-income market, driving bond values to vertiginous highs and forcing the yield on the 30-year Treasury to dip below 4.6 percent this week, even lower than it achieved last year. Maintaining a bearish outlook on bonds is getting harder, even when the evidence seems to be on the side of the furry forecasts.
Never mind that oil is staring down the barrel of $50 again, the Federal Reserve is on a mission to drive its key interest rate higher, and the U.S. government is expected to say tomorrow that its economy grew at the fastest pace in five years in 2004. Bond prices ignored the warning signs in 2004; maybe they'll do the same in 2005. The market can stay irrational longer than you or I can stay solvent.
So far this year, bond and stock markets are confounding investors' expectations. Some 68 percent of investors viewed bonds as overvalued at the beginning of December, according to a Merrill Lynch & Co. survey of money managers, with $926 billion at their disposal. Some 77 percent of those respondents expected equities to be the best investment for 2005, with 45 percent predicting bonds to perform worse than either stocks or cash.
Stocks Versus Bonds
That's not how things are turning out. The benchmark Standard & Poor's 500 index is down 3.6 percent this year. That's a bearish signal for believers in the so-called January effect, which holds that the direction of the stock market in the first month of the year sets the tone for its annual performance.
U.S. government bonds maturing in 10 years and more, meantime, have delivered about 1.5 percent this year. The benchmark 10-year note yields about 4.2 percent, within 6 basis points of its 2004 average.
Stocks are declining even though more than two-thirds of the 157 S&P 500 index members who'd reported earnings by Jan. 25 had beaten analysts' estimates, according to Thomson Financial data. And bonds are making money even though there's more and more evidence to back up the Fed's repeated assertion that interest rates are too low given the outlook for growth.
Tomorrow's U.S. gross domestic product report may show the economy grew 3.5 percent in the fourth quarter, making 2004's rate 4.4 percent, according to the median estimate of economists surveyed by Bloomberg News. Earlier this week, the Conference Board's January index of consumer confidence unexpectedly jumped to a six-month record, as optimism about the current economic situation reached its highest level since May 2002.
Growth Everywhere
It's not just the U.S. driving the global economy. Growth in China accelerated to 9.5 percent in the fourth quarter, while the U.K. expanded 0.7 percent, both outpacing economists' expectations. Even in seemingly moribund Germany, business confidence unexpectedly jumped to an 11-month high in January.
That batch of good economic news from around the world this week should give bond bears some comfort. The 10-year yield is forecast to climb to 5 percent by the end of the year, based on the median forecast of the 22 primary dealers that trade directly with the Fed. Unfortunately, that mirrors the 2004 forecast that proved wrong; the 10-year yield ended December at about 4.2 percent, instead of the 5.05 percent anticipated in the year-ago survey.
Will the bond bears do better in 2005? Last year's forecasts were tied to ``interest rates going up, an inflation scare because of rising commodity prices, and growth ticking along nicely,'' says Steve Major, global head of fixed-income strategy at HSBC Holdings Plc in London.
Recycling Dollars
While those concerns were justified at the time, 10-year yields still didn't rise. Major cites the U.S. government selling fewer bonds than it did a year ago, job growth still too slow to push wages higher, and a decline in commodity prices as reasons to be bullish on bonds. Moreover, China and the world's biggest oil- producing countries will continue to recycle their dollars into the U.S. Treasury market, he says.
At 4 percent, HSBC already has the lowest year-end 10-year Treasury forecast of the 22 primary dealers. ``If anything, the risk to our 10-year forecast is that it's on the high side,'' Major says. By January 2006, HSBC expects the Fed to be cutting rates, and the 10-year yield to be at 3.9 percent, he says.
Lehman Brothers Holdings Inc. expects the U.S. government to sell about $722 billion of new notes and bonds this year, a 15 percent cut from 2004's record sales. Its forecast for the 10-year Treasury by December is in line with the consensus, at 5 percent. The most bearish forecast is from JPMorgan Chase & Co., which sees a 5.8 percent yield by the end of the year as accelerating inflation overshadows the decline in bond supply.
With five of the Fed's interest-rate increases already out of the way and bond prices still showing no signs of acrophobia, maybe it's time for the bond bears to throw in the towel --because no matter what they think the economy is telling them, the price action in the market seems to say the opposite.

To contact the writer of this column:
Mark Gilbert in London magilbert@bloomberg.net.