Nobody Saw The Yield Signs

A bad case of whiplash. That's about the only way to describe what government-bond traders have experienced since the beginning of May. In just six trading sessions, 30-year Treasury bonds rallied almost half a percentage point before stalling on May 10. That move sent the yield of long bonds down to about 7%, its lowest level in more than a year. Between furious bouts of trading, flummoxed traders tried to make sense of a dramatic move that few had forecast.

What caused the about-face in market sentiment? Weaker-than-expected auto sales, retail sales, and employment numbers are the main factors. Such signs of economic slowdown all but wiped out inflation fears. "Recession, recession, recession: That's the buzzword [on the trading floor]," says Chicago Board of Trade Chairman Patrick H. Arbor.

Few trading houses and banks will admit to taking a hit, but traders say many firms, including some primary dealers of government securities, were shorting Treasuries as recently as May 3. Then came April's employment report, released on May 5. Its higher-than-expected jobless figures sent investors scrambling to cover short positions. "You could see a lot of what you'd almost call panic buying," says Arbor.

The severity and swiftness of the move in bonds was largely unexpected. Daniel J. Callahan, head of government securities at PaineWebber Inc., calls it "one of the most startling rallies the market has seen in a long time." Indeed, since Jan. 1, the long rate has fallen about one percentage point. Economic fundamentals can explain the downward direction, but Callahan ties the magnitude of the move to foreign central banks buying dollars--more than $40 billion so far this year--and putting money into two-year notes.

The Bank of Japan has been a big buyer, says Alfred Kingon, head of investment firm Kingon International and former U.S. ambassador to the European Community. To keep the yen from bouncing higher, "they're buying our bonds, driving the market up, and stabilizing the dollar for the short-term," he says. Traders betting the Japanese support plan would fizzle took big short positions in notes, says Leslie Rosenthal of Chicago trading firm Rosenthal-Collins Group: "Guys were waiting for Japan to dump."

That's just one reason for all the action in Treasuries. "There is significantly less corporate issuance in the world, because corporations need less money," says Peter G. Hirsch, head of the government desk at Salomon Brothers Inc. Also, fewer mortgage securities are being created. Such a shortage of paper makes Treasuries all the more alluring.

WHY NO CHEERS? A rush out of mortgage-backed securities also contributed to the incredible shrinking Treasury yield. If the Fed were to lower rates to stave off a recession, prepayments on mortgages would speed up. That scenario has money managers and investors seeking noncallable paper to lengthen the duration of their portfolios. That means buying more government bonds.

Why aren't the Wall Street firms raking in the bucks and cheering this decline in rates the way they did in 1993? True, investment houses have an inventory of bonds, and their fortunes improve anytime interest rates go down. But this time, inventories of Treasury bonds were probably too thin to yield any significant profits. "Some traders may have been bullish on bonds, but after being kicked in the head by last year's bond market, they probably didn't have the courage of their convictions," says Joel Unger, a partner in New York investment management firm Stralem & Co.

Where do rates go from here? Naturally, a lot depends on how sharply the economy slows and how the Fed reacts. "The market is implicitly forecasting that the Fed will ease by 50 basis points in the next six months," says the head of fixed-income trading at a major investment house. He regards that possibility as "highly unlikely." Salomon's Hirsch agrees that rates could go back up. He thinks that the market is ahead of itself, being driven more by technical factors than fundamentals.

Still, recession fears may keep the pressure on yields for the next few months. In the longer term, Unger is willing to forecast that yields could fall to less than 5% "if it appears that we're on a path toward a balanced budget." If so, bond markets could remain turbulent for some time. Traders, beware of whiplash.

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