Bond Vigilantes Keep Close Eye on US Deficit??

There is snow on the ground in New York and growling bond bears may have woken up too early.

The S&P 500 has beaten Treasuries for the past two years and many analysts expect this trend to accelerate in 2011.

Earlier this week, the bears were in full flow after a report on Wednesday indicated a strengthening jobs market, reinforcing the prevailing mood among many investors that the US economy is gaining traction.

The sell-off in Treasuries, however, was fleeting and by Friday a lacklustre US employment report for December had pulled Treasury yields, with the exception of  long-term paper, down to fresh lows for the year.

While the “soft” jobs market reduces the prospect of sharply higher Treasury yields in the near term, the omens remain cloudy for bonds.

In recent weeks, dealers have been selling their Treasury holdings, as have foreign central banks, while some bond funds have been hit by outflows. This month, many retail investors will open their fourth-quarter statements for 2010 and discover the downside of buying bond funds at last year’s lower rates. That could well spark further outflows from bonds.

At its current yield of 3.33 per cent, the 10-year Treasury note sits a percentage point above its October low.

Stepping back, however, yields remain historically low and the big question for investors is: how long can this situation continue?

Much of the demand for global risky assets has been fuelled by record low interest rates and central banks buying bonds, not rocketing economic growth.

For more than two years, the line in the sand for the 10-year note yield has been 4 per cent, reinforced by annual US core inflation dropping below 1 per cent from 1.7 per cent over the past year.

Bond bulls rightly argue that inflation will not arrive with high unemployment and anaemic wage growth.

Some also argue that fears over inflation are misplaced and that higher food and petrol prices will act as a tax on consumer spending and limit the economy’s recovery.

To drive 10-year yields above 4 per cent requires genuine traction in the economy, fuelled by strong job creation and bank lending accelerating to a tempo that leaves the Federal Reserve with little choice but to indicate tighter policy is coming. Such an outcome looms way off in the distance.

So, for all the bearish chatter on bonds, Treasury yields could well surprise investors and stay ‘range bound’ for some time. Moreover, any future test of the 4 per cent level in the 10-year note on better economic data may present another buying opportunity for bonds, particularly should eurozone debt problems and a sharper slowdown in China knock the appetite for risky assets in coming months.

The wild card, however, for Treasuries – like much of Wall Street’s attention these days – may reside in Washington. Already the Republican-controlled House of Representatives is talking about toning down spending cuts, in effect doing little to arrest the ever-rising tide of budget red ink.

If the bond market’s famed “vigilantes” finally decide to flex their muscles over the growing US federal deficit, expect the 10-year note to surge above 4 per cent, but with severe ramifications for equities and risky assets.

The latest salvo from the bond vigilantes arrived this week from Bill Gross, manager of Pimco’s total return fund.

In his monthly investment outlook, Mr Gross warned investors of the risks of too much deficit spending.

“Higher inflation, a weaker dollar and the eventual loss of America’s triple A sovereign credit rating are the primary consequences,” he concluded.

That would vindicate Treasury bears, but with fearful consequences for many investors.