Bond Market Sees Stronger Economy

Money poured out of bonds and into stocks after rosy words on Tuesday from the Federal Reserve gave traders confidence that the economic recovery is strengthening. Major stock market averages are at or near four-year highs.

Treasury yields — and interest rates that take their cues from Treasury yields, including mortgage rates — remain near all-time lows. So while mortgage rates may creep up, they should remain historically low.

Even with the economy getting stronger, the Fed plans to keep short-term interest rates near zero through 2014. And demand is strong for long-term Treasurys because the dollar and the U.S. government still look like safer bets than the euro and other nations.

More evidence of the hunger for U.S. debt came Wednesday afternoon, when the Treasury Department auctioned $13 billion in 30-year bonds. Bids came in higher than current market prices.

The bonds were priced to yield 3.38 percent. Similar bonds trading on the open market fetched a yield of 3.41 percent.

The yield on the 10-year Treasury note was 2.27 percent as of 4 p.m. Eastern time Wednesday. It hasn’t closed above that level since Oct. 28, but the yield is far lower than the 3.36 percent level where it settled a year earlier.

Prices rose and yields fell for U.S. government debt almost all last year. Investors were willing to pay for the safety of U.S. debt because other investments, like volatile stocks and the euro, seemed much riskier at the time than they are today.

The interest rates that Americans and businesses pay on mortgages and other loans tend to track the 10-year note, and rising yields should make the interest rates on those loans increase.

With the spring home-buying season about to start, the average interest rate on the most popular mortgage loan, the 30-year fixed, fell last week to 3.88 percent, a hair above the 3.87 percent it hit three weeks ago. That was the lowest since long-term mortgages were popularized in the 1950s. A year ago, the average was 4.88 percent.

If mortgage rates rise from the all-time lows where they have coasted for months, fewer people will try to refinance their loans, said Greg McBride, senior analyst with Bankrate.com.

“It does have an impact on refinancing traffic, which is far more sensitive to every fluctuation in rates,” he said. But McBride said rates are still “super-low,” and homebuyers are unlikely to make decisions based on a move of a few hundredths of a percentage point.

Interest rates haven’t been the main barrier to borrowing and lending in this sluggish economy. Banks say they’re not getting enough applications from borrowers with good credit. Borrowers say banks’ lending standards have tightened so much that almost no one can clear the bar.

In the bond market, traders have been selling bonds mainly because the Fed’s view of the economy has improved markedly. The Fed said in a policy statement Tuesday that it saw signs of strength in hiring and spending by consumers and businesses. It appears less likely that the European debt crisis will cause financial upheaval here, the Fed said.

Later Tuesday, the Fed said that all but four of the 19 biggest U.S. banks are strong enough to raise their stock dividends and still be able to withstand a financial crisis worse than what happened in 2008.

When traders believe the economy is improving, they tend to sell bonds — which are relatively safe but offer limited returns — and buy investments such as stocks, which tend to rise in periods of growth.

That’s what happened on Tuesday. Stocks had their strongest daily rally of the year, while bonds sold off.

The Fed’s words carry extra weight because the Fed is the biggest player in the market for Treasurys. Traders have been waiting for signals about whether the Fed plans to engage in another round of bond-buying, which would increase overall demand and make their Treasury holdings more valuable. Tuesday’s announcements made that appear far less likely.

Investors have streamed into bond funds since the market crash of 2008. Bonds were delivering strong returns, and many had lost confidence in the stock market after its implosion. McBride said many of these investors aren’t prepared for the losses they would face if the economy grew strongly or if inflation rose.

For people who keep their money in savings accounts and CDs, meanwhile, any rise in long-term rates will have little effect. The Fed is keeping short-term rates near zero. A six-month CD tracks the tiny yield on the six-month Treasury bill. Both assets compete for the same investor dollars.

In the market for short-term debt, the yield on the three-month T-bill has held steady at 0.08 percent for the past week.

The Fed isn’t the only reason why yields fell to historic lows. Banks, governments and investors all over the world streamed into the market for Treasurys over the past two years because many feared that the debt crisis in Europe would touch off another global financial crisis. Euros and debt issued by other governments look far riskier than U.S. investments.

The yield on the 10-year note fell below 2 percent in September mainly because of those concerns.

As confidence returns to the market, traders and investors should watch for rising rates and falling bond prices, McBride said. He said it’s not clear when the long-term trend will turn positive.