Fed May Spook Bonds, but Cyprus Could Curb Downside

The outside chance that seemingly endless monetary stimulus could be on the road to withdrawal may upset bonds, yet traders expect Europe's latest troubles to limit any potential downside.

The 10-Year Treasury note has enjoyed a massive rally over the last three sessions, with yields hitting their lowest level in three weeks. Some investors are being drawn to bonds ahead of the U.S. Federal Reserve's policy decision on Wednesday.

The Fed's efforts to support an economic recovery has sent stocks on a tear, but also put a floor under bond prices. In September, it launched a third round of quantitative easing (QE), in which it will buy $40 billion of mortgage-backed securities per month, primarily in mortgage-backed bonds. Those open-ended purchases mean they will continue to flood markets with cheap liquidity indefinitely, in order to drive down unemployment.

(Read More: CNBC Explains the Federal Reserve)

There have been several signs the economy is starting to pick up, which only recently led traders to dump bonds and drive up yields. Yet Wall Street will closely monitor the Fed meeting to see whether chairman Ben Bernanke will provide a timeline for when QE will come to a close.

To David Robin, a veteran futures broker, it's probably too late to get long the 10-year ahead of the Fed meeting, however.

(Read More: Fed to Remain Wall Street's Sugar Daddy: CNBC Survey)

"The Fed is going to have a very difficult time overlooking the data," said Robin, co-head of financial futures and options at Newedge.

The FOMC needs to start "thinking a little bit more about extracting themselves from the 'on hold for long' policy," he said. A statement that acknowledges inflation risks could signal an end to QE at some point in the future.

While it won't happen right away, Robin thinks the Fed may soon need to mull an exit strategy. That could have implications for Treasurys, by putting selling pressure on bonds. In turn, rising yields may lure in more investors.

Yet any reaction to the Fed could be curbed by the impulse to use government debt as a safe-haven from Europe's debt turmoil.

Trader Jim Iuorio noted that Treasury markets have maintained gains following news that Cyprus plans to partly pay for a multi-billion bailout by taxing bank depositors.

"This indicates to me that global unease has the potential to push money into the relative safety of U.S assets. In this scenario, I believe that equities and treasuries can rally together," Iuorio said. "Continued global uncertainty also strengthens the case for continued Fed bond purchases, which will support bond prices."

U.S. Treasury
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U.S. Treasury

To play it, Iuorio suggests buying the June 10-Year Treasury futures at current level of $131.11, with an upside objective of $132.10 and a stop of $130.27.

Chicago Mercantile Exchange trader Jeff Kilberg of KKM Financial agreed.

"I don't think the grab for Treasurys is over. We're going to continue to see these yields come down here," said Kilburg, on CNBC's "Futures Now."

Bonds have "a lot of momentum," Kilburg said. "We're seeing some big curve trades come into the pits today, so there's a lot going on and so I want to be long here."

Kilburg plans to buy the June contract for the 10-Year at $131.18 with a target of $132.07 and a stop at $131.08.

Read on for Can Bonds Rally With Stocks?

— By CNBC's Drew Sandholm

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