U.S. Treasuries had their biggest quarterly gain in four years – can the rally continue?
Sam Adelton
Sep. 30, 2006

The immediate effect of Fed pausing and economic slowdown in US is well manifested in U.S. Treasuries having their biggest quarterly gain in four years. The rally was impressive. The ten-year note yield fell from 5.2% to 4.6%. Along with Treasuries the fixed mortgage rates also fell. The biggest question now is what is there for future in US Treasuries?

In order to answer that question, we need to look at what was behind the rally? Please note while bond market was rallying US Dollar also rallied again Yen and lesser extend against other currencies. Some analysts are saying bond market is telling Fed that they have raised the rates too far. It may not be true. As a matter of fact bond market is probably telling Fed it did a great job because their action will control inflation in the long run. That is why dollar also rallied.

There is another major factor. Most likely Bush Administration is now getting serious about budget deficit and more importantly the trade deficit. They will not tolerate the status quo in the rest of the world that continues to dump their product and services to US. In other world the buying power of US is now getting focus. The trade deficit can disappear if US closes its door to imports. The US dollar’s strength comes from lower term inflation expectation and assertion of US Department of Commerce on equal playing ground in Trade and Commerce.

While the bond market has rallied, one thing is for certain, the yield curve got inverted. That is negative for the economy. Federal Reserve will not lower the rates so easily – at least for now. That can be seriously negative for the US economic expansion. If US economy slips into a recession, countries that export to US will get much more affected that US. That is why dollar is staging some solid rallies.

Given a stronger dollar, a possibility of a recession in US (or lower growth) the bond market looks good. However there are risks. The budget deficit is high and is funded by the Asian buying of US Treasuries. If that for some reason is halted or rate of buying slows down, it will very bad for long term interest rates in US.

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