Analysis: Higher U.S. bond yields could impede economic recovery

Sun Feb 3, 2013 12:02pm EST
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By Richard Leong and Ellen Freilich

NEW YORK (Reuters) - A rough couple of months in the U.S. bond market has lifted interest rates off record lows and now could impede a slow economic recovery heavily dependent on cheap money to keep going.

While stocks have surged to near-record levels from five years ago, an accompanying rally in the $11.6 trillion U.S. Treasury debt market appears to have run out of steam and bond prices have dropped steadily since early December. That has pushed up bond yields, which move in the opposite direction to prices and they are now at the highest levels since last spring.

Some of what's behind the sell-off can be seen as positive - greater investor confidence in riskier assets such as stocks, signs the European debt crisis is abating and a spate of U.S. economic indicators that point to more growth.

As bonds fall out of favor, however, credit-sensitive corners of the economy could start to feel the pinch. The housing market, car sales and business and public sector investment will be vulnerable as the cost of borrowing rises because all credit costs are ultimately tied to the Treasury market.

"I do fall into the camp of people who worry what will happen when rates go up," said Tom Nelson, chief investment officer at New York-based Reich & Tang, a firm with nearly half of its $28 billion in assets under supervision in money market mutual funds.

Of course, the demise of the three-decade bond-market rally has been forecast repeatedly in recent years. Just last March, Bill Gross, manager of the world's largest bond fund, the PIMCO Total Return fund, sharply cut his exposure to U.S. Treasuries. Bonds proceeded to rally through November, driving the yield on the benchmark 10-year Treasury note to well below 2 percent.

The threat of a major sell-off remains distant in many investors' minds because the market enjoys one big source of demand - the U.S. Federal Reserve. As part of its latest effort to prop up the economy by flooding the banking system with cash, the Fed has been buying $85 billion of Treasuries and mortgage bonds from banks each month since September and has no plans to ease up anytime soon.

RISING RATES   Continued...