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Tue, Jul 11, 2000
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Going Long in Treasuries Still a Safe Play
By Harry Milling
DATELINE — Who would have expected that boring Treasury bonds, with their fixed income, would become a hot investment this year after 1999's charging bull market in stocks?

The Lehman Brothers Long Treasury Bond Index is up 8.4% year to date, outstripping the 4.9% return of the go-go Nasdaq Composite Index over the same period.

Bond prices move in the opposite direction of yields, so yields have fallen, particularly on the long end of the yield curve. The yield on the 30-year bond is down 14% since a peak in January to its lowest level in almost a year. And the yield on the 10-year note has fallen 13% since a peak in January to its lowest in almost five months.

What seems bizarre is that yields have declined despite the fact that the Federal Reserve is raising short-term interest rates to slow down torrid economic growth, which it fears will lead to inflation.

Have yields declined too far and too fast considering more rate hikes are likely? If so, then those portfolios that have loaded up on 10- and 30-year Treasuries are in danger.

My contention is that the bond risk of these portfolios is not that high.

A slew of key inflation data this month could lift yields and drop prices on 10- and 30-year Treasuries. I expect the 10-year yield to trade comfortably above 6% this month. But yields won't revisit this year's highs. That's because there are other factors at play that will continue to undergird prices on the long end. The uptrend in 10- and 30-year Treasury prices may only be stymied--not derailed--this month.

Treasury Market Not Rate-Hike Immune The Treasury market has reflected expectations of tighter monetary conditions to a certain extent.

The yield on a two-year Treasury note has been bearing the brunt of rate-hike expectations, as it should. It is most sensitive to the Fed's benchmark rates and the most actively traded. The yield has dropped only 4% since its peak in February.

This has inverted the yield curve between the two-year to the 30-year issues, meaning it has made short-term credit more expensive than long-term, in keeping with Fed's wish for an economic slowdown. Following its pattern, the two-year yield will rise the most if coming economic data raise expectations of more aggressive tightening.

The inverted yield curve will remain intact, because even if yields on the 10-year and 30-year Treasuries rise, it won't be by much.

Other Factors at Play The factors that have boosted prices of Treasuries on the long end of the curve continue to be in place.

News in January of a plan by the government to buy back $30 billion worth of Treasuries this year sent investors scrambling for those bonds because they would be the focus of the buyback. Now there is talk in the market that the buybacks will begin to include 10-year notes.

Then there is the wild and wooly stock market. The Nasdaq's record volatility in the past two weeks created doubts about whether equity returns this year would be as juicy as previous years. That accelerated a broadening out of portfolios to include trusted fixed-income investments.

A record $1.018 trillion in retail money market funds as of Wednesday provides a potential reservoir of cash for equity funds, but I think enough concern about equity returns has been raised to prevent a wholesale portfolio shift back into equities--at least in April.

It seems some bond players are so bullish that there is even a theory going around that says 10-year and 30-year Treasury prices will rise even if there is strong economic data that raise fears of aggressive rate hikes. The thought is that rate fears will prompt an equity sell-off that triggers more safe-haven Treasury buying as we saw during the Nasdaq rout earlier this week.

But that is an unlikely scenario, because the technology-stock sector is not as vulnerable to rate-hike concerns as other sectors are. The shaken equity market doesn't rule out another wholesale sell-off, however.

Agencies Still an Agency of Treasury Buying Since the announcement of the buyback, Treasuries on the long end have been bought at the expense of debt issued by government agencies that buy mortgages. Corporate debt has also been dumped for Treasuries.

The general reason is there will be much more corporate and agency debt issued than government debt, a supply issue that won't be changing in the short term and probably not in the long term either.

Thus, in the fixed-income arena, Treasuries on the long end likely will continue to outperform even amid rate hikes. The real question remains whether they will continue to outperform equities.

Harry Milling is Morningstar.com's market commentator. He welcomes e-mail but cannot meet requests for customized portfolio advice. He can be reached at harry.milling@morningstar.com.

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