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Bond Market Selloff Signals Higher Rates Ahead

Wednesday, 14 Mar 2012 | 3:18 PM ET

The selling wave that hit the Treasury market this week reflects an improving view of the U.S. economy and could be the start of a period of slightly higher interest rates.

Savings Bonds
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Savings Bonds

The yield curve Wednesday was at its steepest since October, and even a 30-year bond auction failed to stop the selling. Rates, which move opposite to prices, rose to their highs of the day, after the $13 billion auction at 1 p.m.

“I think this has really spooked people now. The auction didn’t go that well, and rates are at the upper end of the (day's) range. We broke through some key psychological levels — 2.25 on the 10-year,” said George Goncalves, Treasury strategist at Nomura Americas.

The 30-year yieldtouched 3.425 percent mid-afternoon and the 10-year was yielding 2.279 percent, both levels last seen in late October. The 10-year yield is closely watched since it affects a whole range of consumer lending rates.

Can the U.S. Afford Higher Rates?
CNBC's Rick Santelli & Kelly Evans discuss rates on the 10-year and 30-year notes.

“It’s a good thing because rates are rising for cyclical reasons, meaning increasing demand for capital and an improving economy,” said Joseph LaVorgna, chief U.S. economist at Deutsche Bank . “Certainly corporations want to borrow a lot of debt. We’ve been seeing that. This is healthy, I think, and rates would have to go up significantly for the economy to suffer.”

Corporations so far this year are issuing debt at a record pace. Last week, a record $40.6 billion in investment grade corporate bonds came to market, according to Thomson Reuters IFR. The quarter is on pace to be the biggest ever, likely to surpass Q1 2011’s record $259 billion.

“I think going forward the question is how much more can 10-year yields go up. I think it really continues with this next batch of data,” said LaVorgna.

Bond market strategists say the bond market reversal is the result of a combination of factors, including less concern about Europe’s sovereign crisis now that Greece has restructured its debt. Improving U.S. jobs data and signs that the housing could be healing are also negatives for bond buying, as are signs that perhaps the Fed may not be ready to do more easing.

More quantitative easing?

The Fed has said it could do more quantitative easingif the economy required it. Under a third QE program, the Fed has said it would consider buying mortgage securities in an effort to help housing and send rates lower. The Fed met Tuesday and ended its meeting with a slight upgrade of its economic view but no clear message on whether it would carry out more easing in coming months.

The Fed also did not say what would happen when its “operation twist” bond program ends in June. That program involves the purchase of longer duration Treasurys, while the Fed sells a similar amount of shorter duration notes, in an effort to drive down long term rates.

Yields touched their lows just before the Fed announced operation twist in October. The 10-year had a closing yield of 1.72 in late September.

“We had a slightly more optimistic FOMC statement, plus successful bank stress testing showed the U.S. banking system to be on better footing than its European counterparts,” said Ian Lyngen, senior Treasury strategist at CRT Capital.

Lyngen said the strength of the equities market rally has also been a factor behind bond selling, but so far there is no stampede into equities. “The relationship between the rally in equities and the sell off in fixed income now makes more intuitive sense than it did last week,” he said.

As yields rose, stocks fluctuated and were slightly lower Wednesday afternoon, after Tuesday’s big rally. “The big debate is — is this the beginning of the massive switch out of Treasurys and bonds and into equities. The fact it’s slow and calm doesn’t panic anyone,” said Art Cashin, UBS director of floor operations at the NYSE . “It’s the watch and wait period. Nobody wants the switch to happen when they’re not on board.”

Goncalves said it appears investors are piling out of bonds but are sticking in cash for now. He has been calling a bottom in rates since January. “Animal spirits were dead, and now they’re being rekindled,” he said.

“I do believe it’s making a lot of investor that recently became bond bullish after being bond bearish to rethink the rationality for these trades. Most of the buying took place around 2 percent. Now they’re about 2 basis points under water,” he said.

“I don’t think the Fed cares unless we get above 2.50 [10-year yields],” Goncalves said. “I’ve been calling 2.40. That’s where we should be normalizing.”

There are several catalysts to keep the selling going for awhile longer, he said. One reason is the end of year in Japan is March 31 and Japanese buyers of U.S. Treasurys will stay sidelined until after that date.

Follow Patti Domm on Twitter: @pattidomm

Questions? Comments? Email us at marketinsider@cnbc.com

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  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

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