Bond Market Profile -- Brazen Bulls

10 Year Treasury: 3.91%, 30 Year Treasury: 4.24%

The Treasury Bond market normally prices off the FFR or 91 Day T-Bill rate. Based on very long term relationships, the Bill, at 2.99%, implies a long bond yield of 4.50%. This relationship is a rule of thumb, not a precise axiom of the game.

Short rates are too low relative to the recent inflation range of 3.0 - 3.5%. The Fed, leery of the strength of the economic expansion, has brought rates up very slowly. The Fed has faced a headwind, too. The ratio of short term credit demand to the supply of loanable funds in the system although rising sharply, is still quite low relative to the supply of loanable funds. Rather than drain permanent reserves and imperil the economy, the Fed has been pressed to move short rates up in small increments. A fine point perhaps, but an important one to keep in mind.

Bond managers, reluctant to sacrifice yield in the environment by staying short, have pressed to pick up yield along the curve and through adding spread by downgrading quality. The Treasury bond yield barely protects the purchasing power of the money invested in it, but it is still better than taking a very short duration position.

The recent sharp rally in bonds dating back to mid-2004 reflects bond manager awareness that basic cyclically sensitive data is flattening out, indicating a continuing economic slowdown that managers expect will eventually lead to lower inflation readings. So the bond market has felt comfortable long despite the nominal premiums in yield over inflation because expectations are strong in favor of a deceleration of inflation resulting from the slowdown.

There is no "conundrum" here. Bond manager behavoir has been normal. The group can get uneasy, however. Signs of economic strength or a short term boomlet in commodities prices can add 50-100 basis points to yields in short order. But so far, the underlying consensus conviction that inflation is headed lower, perhaps to 2.0% or slighly less remains strong.

As mentioned last week, the bond market is overbought and sentiment as measured by the normally reliable Market Vane survey of bond traders is now far too bullish, with 76% of repondents recommending the long side. It would be a surprise not to see the 10 year Treasury head right back up to 4.50% or beyond in the next several months.

One thing to watch out for is when the Fed says it has reached its goal of removing accomodation and is now in a neutral posture. Since "removing accomodation" has been a euphemism for tightening the reins, a neutral posture might well be consistent with rate and liquidity moves in either direction. This change could increase uncertainty among bond players and result in some premium building in note and bond yields, since it opens the question of whether the economic slowdown might soon end and give way to faster growth.

Link to a nice long term chart of the Treasury here. It shows the long term bull market in bonds is still intact. Note that as in the past we are basing under the yield downtrend line. I suspect if monetary policy is again set to support moderate growth, the downtrend line will likely be challenged once more.