Behind the Bounce in Treasury Yields

Ever since the Federal Reserve announced that it would begin buying large quantities of Treasuries in mid-March, the rate on the 10-year Treasury note has stayed below 3%. And many investors expected it to stay that way, with the perception that the Fed wanted to hold rates down to encourage lending to individuals and businesses. Many observers thought that 3% would be the central bank's "line in the sand"—and that it would pick up the pace of Treasury purchases to keep the 10-year note at around 3%.

That changed on Apr. 29, when the Federal Open Market Committee met and maintained the status quo, rather than aggressively stepping up its purchase of Treasuries (it's only used $77 billion of the $300 billion it said it would spend).

Rates surged over 3%, and on May 1 the 10-year closed at 3.15%. "The Fed didn't have a line in the sand," says Brian Brennan, manager of the T. Rowe Price (TROW) US Treasury Intermediate and Long funds. "But the market thought they did."

So why did the Fed let the 10-year rise? Chalk it up to a change in the economic weather. When the Fed announced its purchase plan on Mar. 18, the economy appeared to be in free fall. The pace of unemployment was picking up, mortgage rates remained high, and there were few signs that Fed policy or the government stimulus was slowing the decline.

Economic Optimism

What a difference a month-and-a-half makes. Now, job losses seem to be stabilizing, signs of life—though small—may be appearing in the housing and automobile markets, and discretionary spending may be stabilizing. "The economy looked like it was going down an elevator shaft from the 10th floor to the fifth floor in quick dispatch," says Gary Cloud, co-manager of fixed income for AFBA Funds. "We're starting to do a little bit better here."

And investors are starting to want to take risks with their money. They're buying stocks (the Standard & Poor's 500-stock index is up 10.11% since quantitative easing was announced on Mar. 18), and gains are being seen in leading indexes of municipals (+3.05%) and corporate bonds (+2.36%). They're even piling into junk bonds (+2.09%).

"When you start to see high yield rally from very distressed levels, the flight to safety is over," T. Rowe's Brennan said.

The numbers bear him out. From a low of under 2.5%, 10-year Treasury yields are now over 3%. At the long end of the yield curve, 30-year Treasuries have seen rates rise from under 2.5% to over 4%—and an investor who held onto the 30-year would have lost nearly 30%.

Letting Rates Rise

With the government looking at unprecedented levels of debt going ahead—some experts estimate that it could need $1 trillion a year for the next 10 years—the Fed had little choice but to let rates rise to make demand meet supply. "We have a shortfall in the amount of foreign buyers able to buy Treasuries vs. the amount of debt we're offering," says Dory Wiley, CEO of Commerce Street Capital.

But the Fed has to tread carefully. Mortgage rates are based on the 10-year note yield, and as those rates rise, so will the rates consumers pay on their 30-year home loans. Remember, this whole exercise in quantitative easing began with the need to lower interest rates so Americans could refinance their debt at lower rates, and the Fed will have to do what it can with its remaining $223 billion to keep rates from rising too much.

Experts expect rates on the 10-year Treasury to settle into a range someplace between 2.8% and 3.50%. "The Fed will use its ammo when it needs it," says Peter Greig, co-manager of fixed income for the AFBA Mutual Funds. "I don't think 10-year rates get to 4%. But the Fed's not going to be able to push it to 2%, either."

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