Treasury Rally, and Drop in Yields, May Last

By MARK GONGLOFF

Forecasters are actively cutting their outlook for 10-year Treasury yields, an acknowledgment that the latest decline in rates may be more than a brief dip.

The recent drop in Treasury yields—to 3.296% on the 10-year note on Tuesday—caught economists and investors by surprise. While economists are revising their predictions, many investors have been a little slower, continuing to post near-record bets that U.S. Treasury yields will rise.

Many have been caught flat-footed by the sudden move into Treasurys because it has been driven by a rush to safety amid the ballooning euro-zone debt crisis, a stampede that was difficult to predict a few months ago. As buyers piled in, prices rose and yields—which move inversely to prices—fell.

Treasury yields are now trading near their lowest levels in a year, the bottom of a trading channel that has persisted for about 12 months.

That has upended the widespread view at the beginning of the year that Treasurys would seem less attractive amid a recovery in company profits, a rebounding U.S. economy and an avalanche of Treasury debt issuance. Less than two months ago, the 10-year yield was flirting with 4%.

"A lot of people didn't see the latest rally coming," said Zach Pandl, economist at Nomura Securities International. Nomura in mid-April was one of the first of several so-called primary dealers—banks authorized to deal directly with the Federal Reserve—to cut its year-end forecast for the 10-year Treasury yield, to 3.75% from 4%.

Since late March, most primary dealers have cut their year-end predictions for 10-year note yields, according to a survey by The Wall Street Journal, driving the median forecast to about 3.75% from 4.15% at the end of March.

RBC Capital Markets and Jefferies & Co. Inc. cut their forecasts for the 10-year note on Tuesday. Bank of America Merrill Lynch and UBS cut their forecasts last week.

"What we did not anticipate was that 10-year notes and 30-year bonds would become the global safe haven during the European crisis," said Jefferies chief economist Ward McCarthy, who said he believes yields will soon resume their rise.

Jefferies now has the highest 10-year yield forecast among primary dealers, supplanting Morgan Stanley, which on May 10 slashed its outlook from 5.5% to 4.5%, citing the European crisis and the likelihood of the Fed keeping short-term rates lower for longer.

RBS Securities Inc., is likely to cut its rate outlook from 4.4% when its forecast committee meets later this month, said RBS Treasury strategist William O'Donnell.

"It's going to change, and it's likely to be lower," said Mr. O'Donnell, who suggested he would lobby for a significantly lower forecast. "We're about to face fiscal austerity, a threat to growth and for further disinflation, which should support Treasury prices."

HSBC Securities, which has long had the lowest forecast among primary dealers for Treasury yields, has kept its year-end 10-year note forecast at 3%. Goldman Sachs has held firm to its second-lowest year-end forecast of 3.25%. Cantor Fitzgerald, which in late March expected the 10-year note to end the year at 4.15%, was the only primary dealer unavailable for comment.

Economists and analysts, meanwhile, generally think yields will eventually end the year higher, even as they have lowered their forecasts.

"I think we have a sustainable expansion in the U.S., and inflation, though it will remain quite low, is not going to slip into Japan-style deflation," said Mr. Pandl of Nomura. "The inflation outlook is really the biggest point of uncertainty—if you're going to get lower yields, it means you're going to have some deflation scenario for the economy as a whole."

The risks for Treasury bond bulls include economic growth that is stronger than expected and a cooling of the European debt problems that have driven investors into Treasurys. These would help remind investors that the Treasury Department is still borrowing heavily, a situation that could bring higher yields, as it did in Europe.

Investors meantime are still placing large bets that yields will rise.

In the week of April 13, the net number of speculative "short" bets against the 10-year note rose to its highest on record, according to data from the Commodity Futures Trading Commission.

At the time, the 10-year note yielded 3.81%. Between April 13 and May 18, it tumbled to 3.376%, causing deep pain to those who were short.

Many short positions closed during that stretch, though the number stayed high and returned to a near-record in the week of May 18.

At that point, the 10-year yield was at 3.376%. In the week that followed, it tumbled to 3.158%, causing more pain for those betting against Treasurys.

Still more shorts closed their positions during that week, possibly contributing to the 10-year note's most recent rally. In the week of May 25, according to CFTC data released last week, the net short position against Treasurys was the lowest since March 23, though it remains historically high.

Many investments against longer-dated Treasurys aren't one-way bets but have been hedged by other investments, such as bets that short-term rates will stay low, notes David Ader, head of government-bond strategy at CRT Capital Group LLC. That could help offset recent losses in 10-year Treasury futures.