The Name Is Bond

Story Highlights:

• The yield on the 10-year US Treasury bond ticked up to 3.7% as investors sold long-term bonds.
• The sell-off in US assets came in the wake of three US Treasury auctions and the earlier revision of the UK's credit rating outlook from stable to negative.
• But rising rates are a fairly normal market phenomenon and could be a sign of economic turnaround and less risk aversion.
• Rising Treasury yields have helped tighten the spread between Treasury and corporate bond yields, which is a positive for the market.

__________________________________________________________________________________________________________________

A deadly agent with a license to kill. That's what folks feared this week. And the name was Bond…Treasury Bond.

Yep, bond woes made headlines last week, as investors dumped long-term US Treasuries. Why the sell-off? Many cite inflation concerns and excess supply following three Treasury auctions last week. Meanwhile, Standard & Poor's lowered the to "negative" from "stable," sparking fears of a similar fate for the US. (These fears were alleviated when Moody's announced the US government's AAA credit rating .)

The sell-off and auctions combined to push the yield on 10-year US Treasuries to 3.7%—the highest since September. A big spike generally spooks investors—yet folks forget bonds can be volatile, just like stocks. Still, Treasuries flooding the market has investors worried about falling demand, especially given the government's steeply increased deficit spending plans. Others fear higher yields signal higher inflation is already here—citing the recent decline in the US dollar and higher oil prices. Higher inflation along with an oversupply of little-wanted debt can't be a good scenario!

First, the dollar's relative strength and oil prices aren't reliable inflation indicators. Historically, there's no meaningful correlation between them and the rate of inflation. But neither is the Treasury situation so dire. Sure, long-term Treasury yields rose from 2.2% in January to 3.7% now, but this is essentially the same level as early September—before Lehman's bankruptcy. Rates returning to "pre-crisis" levels shouldn't alarm. Furthermore, while higher than they've been in six months, current yields are still pretty darn benign.

But more importantly, rising rates can be a sign of economic turnaround, as Treasury yields typically move higher in anticipation of better economic conditions. See it this way: Investors are confident enough to demand a higher rate to lend their money. Also, there was a huge "flight to safety" last fall. We may be seeing the reversal now—which means equities could benefit. We saw a very similar spike in June and July of 2003—shortly after the beginning of the last bull market. It didn't signal Armageddon then and we don't think it does now.

Little noted in the bond commentary last week is the tightening of credit spreads, which has largely gone unnoticed. Yes, Treasury yields have risen, but higher-risk rates are also falling—7 to 10-year corporate spreads are currently near and, in many cases below, pre-Lehman bankruptcy levels. Cheaper credit for higher-risk entities can be seen as a clear improvement in credit markets. Freer-flowing credit—now that's a license to thrill!