Reprieve for bond bears likely brief

NEW YORK: Thursday's sell-off in the US government debt market offered some solace for those who are bearish on Treasuries, but analysts expect the two-month old market rally would resume and push yields lower.

Even the most vocal bear on Treasuries, Bill Gross -- manager of the the world's biggest bond fund -- raised his flagship fund's holding of Treasuries.

His $243 billion PIMCO's Total Return fund reported on Thursday it increased its Treasuries exposure to 5 percent at the end of May from 4 percent in April, as it kept a negative 9 percent short position in dollar interest rates derivatives, reflecting his view that US interest rates will eventually rise and hurt bond prices.

"This rally looks like it has some legs," said Brian Rehling, senior fixed income strategist at Wells Fargo Advisors in St. Louis, Missouri. "It's more difficult to hold these (short) positions."

Since Gross's move to raise his bearish bond bets in March, benchmark yields have fallen to six-month lows with the 10-year yield breaking below 3 percent.

In the second quarter, Treasuries' total return moved into positive territory after a losing first quarter.

So far this year, Barclays Capital's Treasury index has risen 3.07 percent, compared with a 3.49 percent gain on Barclays Aggregate index that gauges the results of all investment-grade US bonds.

Gross's single-digit share holding in Treasuries for the Total Return fund is far less than the 33.8 percent share in the Barclays Aggregate index which the fund references against.

The current Treasuries rally has been fueled by a combination of factors -- signs of slowing US growth, fiscal troubles in Europe and a pullback in higher-yielding stocks and commodities.

On Thursday, the benchmark 10-year yield rose 5 basis points at 3.00 percent on a rebound in the stock market and a mildly disappointing sale of 30-year bonds.

While yields will unlikely surge any time soon, Gross and other bond bears reckon time is on their side, analysts said.

Earlier this week, J.P. Morgan Securities said the share of investors it polled who say they were short, or holding fewer Treasuries versus their portfolio benchmarks, rose to 31 percent, up from 27 percent the previous week. This is the highest level of "shorts" since February 22, 2010, it said.

In the futures market, more speculators expect 1onger-dated Treasury prices will fall than those who bet they will rise.

Non-commercial "shorts" on 10-year T-note futures totaled 337,488 contracts on May 31, more than the 258,916 on non-commercial "longs," according to the latest Commitments of Traders data from the Commodity Futures Trading Commission.

The Treasury yields will likely rise when the Federal Reserve completes its $600 billion bond program, dubbed QE2, at the end of June, analysts said.

The US central bank has been buying $100 billion in Treasuries a month since the start of QE2 last November. Once QE2 expires, the Fed has signaled it will continue to reinvest proceeds from maturing mortgage securities into Treasuries.

Wells' Rehling estimates the Fed would have $20 billion per month from its mortgage holdings to buy Treasuries. This could forestall any sharp spike in yields.

Signs of US growth accelerating in the second half, as the Fed policy-makers are banking on, could also bring bond prices back from their lofty levels.

Moreover, a shift in market focus on the risk of a US default if Washington fails to raise its $14.3 trillion debt ceiling could hurt Treasuries. There is an Aug. 2 deadline past which the government cannot issue more debt to raise cash.

The Wall Street consensus is that such an event is remote. "The market seems completely unconcerned," Rehling said.

Copyright Reuters, 2011