A Funny Thing Happened to the Rally in Treasury Bonds

(MoneyWatch)  Hugh Johnson, a well respected Wall Street veteran, once recited what he called the Analyst's Credo: "If you get it right, try not to laugh."

An April 6 column has proven a source of amusement. It questioned whether it was possible to be too safe and suggested, with the help of some analysts and financial advisors, that investors might be taking far more risk than they realized by crowding into Treasury bonds.

Since then yields on 10-year Treasury bonds have leaped from about 2.9 percent to just over 4 percent before easing back a bit. Anyone playing it safe and moving into Treasuries that day would be about 4 percent poorer (bond prices move in the opposite direction from yields), while those who took a walk on the wild side and bought a fund tracking the Standard & Poor's 500-stock index would be up more than 10 percent, even after the recent correction of the big spring rally.

Like many market developments, the rise in yields caught investors by surprise. The Fed's program to spend billions buying T-bonds - "quantitative easing," it's called - was supposed to depress yields on the bonds and on other long-term debt instruments, such as mortgages.

The Fed's demand was more than offset by sellers forsaking T- bonds and other presumed havens amid emerging signs of financial stability. Yields also were pushed up by an unraveling of the deflation fears that had gripped the market. All of the money injected into the economy from the stimulus efforts of the Fed and the Obama administration, plus the growth they're expected to generate down the road, is ultimately inflationary, sellers reasoned.

They may be premature in declaring the deflation threat dead. While focusing on the trillions of dollars of stimulus money, the new-model bond bears ignore the trillions that have evaporated from bank balance sheets and home values.

And there's more to come. A recent report by the International Monetary Fund estimates that U.S. financial and other entities will write off $1.8 trillion this year and next, with hundreds of billions more coming off the books of European and Asian institutions.

Beyond the deflationary impact of bad decisions, there is the potential impact of a collective bad mood. The huge rebound in stocks in the last three months seems to be running out of gas, suggesting that investors' risk appetite is waning as they grow impatient for evidence of genuine economic recovery.

And it's not as if T-bonds need a deflation scare to rally from here anyway. In the last couple of weeks Wall Street has begun factoring in the prospect of a Fed rate hike this year. A belief that the Fed is on the case and still cares about price stability could be enough to fuel a bounce.

That would be the Goldilocks scenario. A flare-up in deflation expectations and a new overbooked flight to safety would be the One Big Bear scenario. T-bonds would soar, and almost everything else - stocks, low-quality bonds; commodities; real estate - would decline.

The ramifications would extend beyond investment portfolios; whatever economic recovery was in progress probably would be derailed, too. So while buying T-bonds may turn out to be the right call, the malign forces driving the rally would make it no laughing matter.