Treasury benchmark may see 5.50 percent

NEW YORK (Reuters) - The brisk sell-off in bonds may take the yield on benchmark U.S. Treasury notes to as high as 5.5 percent this quarter, strategists said, particularly now that a key psychological level has been breached. The 10-year yield moved decisively above 5 percent on Thursday to its highest level in nearly four years and will probably continue to rise on the prospects for economic growth, interest-rate hikes and elevated commodities prices. Futures markets show the Federal Reserve and other global central banks will continue to raise rates, and commodities prices could feed into core inflation later in the year -- helping drive up sovereign-debt yields globally, bond strategists said.
Against that backdrop, investors may demand higher rates on U.S. bonds in order to compete with returns they hope for from stock and commodities funds, some said. Equities strategists polled by Reuters see U.S. benchmark stock indexes gaining almost 10 percent this year. The Standard & Poor's 500 Index gained 3.7 percent in the first quarter. "People are looking for extra return out there," said Bill Kohli, managing director for global specialist core fixed income with Putnam Investments in Boston, adding that the 10-year Treasury note's rise to around 5.05 percent reflects that. "People will be re-evaluating what an appropriate real rate is, given the equity (market) returns we have had in the first quarter and that commodity prices are up," Kohli said. If the 10-year note's yield, which moves inversely to price, were to rise to between 5.25 percent and 5.5 percent by the end of June, Kohli said "that wouldn't surprise me." As investors continue to shift into competing asset classes that may offer higher returns -- including speculative-grade or "junk" U.S. corporate bonds, stocks and commodities -- outflows from U.S. government debt may weigh on Treasuries prices and send yields higher.
"The 10-year above 5 percent means that the economy has been strong and people are betting it will continue to be" for the rest of 2006, said Brian Reynolds, chief market strategist at M.S. Howells, an institutional brokerage firm in Scottsdale, Arizona. "What we have seen this year is people selling Treasuries to buy corporate bonds, because the economy has been great and (companies') profits have been OK and are expected to be for a long time -- and you buy corporate bonds for the additional spreads," Reynolds said. The Federal Reserve may react to the first signs of the filtering of high commodities prices into core inflation gauges by raising interest rates more than the market currently expects, lifting bond yields, warns Jack Malvey, chief global fixed-income strategist with Lehman Brothers in New York. "The bond markets may be in for more central bank medication," Malvey said, adding that it looks increasingly likely the federal funds target rate could rise to 5.5 percent from the current 4.75 percent, and perhaps higher. Over the next three or four months, the 10-year note's yield could rise to between 5.35 percent and 5.50 percent,he said. "The big picture is that the world economy is in vigorous form, commodity prices will pass through to inflation over the balance of this year, and central banks will be on the hawkish side," Malvey said . There is no guarantee, of course, that a breach of 5 percent means a move to 5.5 percent. The 10-year yield's most recent surge above 5 percent came in March 2002. The yield topped out at 5.47 percent that month before slipping back to as low as 4.19 percent in November of that year. And there are some who expect the world's biggest economy to slow sooner rather than later and therefore don't see the benchmark note's yield moving much higher. "On a longer-term basis, I don't see a fundamental reason for it to go above 5 percent," said Keith Hembre, chief economist with FAF Advisors in Minneapolis. "There is the view that global growth would drive longer yields higher, but decelerating domestic activity in the second quarter and third quarter, and the cumulative effect from the Fed hikes," in slowing economic activity, should keep the 10-year yield below 5 percent later this year, Hembre said.