Another Challenge for Bonds?

It should be pretty clear that I'm bearish on the bond market of 2011. The massive budget deficits and debts we're racking up should hammer Treasury prices. So should the steadily growing concern about the credit quality of sovereign debts.

In fact, Moody's Investors Service just weighed in again on that front. It warned that both the U.S. and the U.K. are "substantially" closer to losing their AAA debt ratings. A key reason? Debt servicing costs — ongoing interest and principal payments — are surging!

By 2013, the U.S. will have to spend more than $1 of every $10 in revenue on debt service under Moody's "baseline scenario." The agency's "adverse" scenario is even worse — calling for 15 percent of revenue going towards covering our debts. And we all know the ratings agencies have historically been too timid when it comes to their predictions. If anything, things will turn out worse than projected!

Now I want to talk about yet another challenge for the bond market. It's a traditional one — better economic data.

Recovery May Be Bought and Paid for in
Washington ... but It's Gathering Steam

Let's be up front about one thing: This is not the kind of blockbuster economy we had in the late 1990s. It's an economy whose growth has been bought and paid for in Washington — using borrowed money! That means it will eventually collapse under its own weight.

But that hasn't happened yet. Instead, all the latest data suggests the recovery is gathering steam ...

• Housing starts and building permits are holding steady in the 550,000 to 650,000 range, rather than deteriorating further. This fits with the major housing market bottom call I made almost a year ago.
  
  
• Industrial production rose 0.1 percent in February, while capacity utilization rose to 72.7 percent. That was the eighth month in a row of improvement in the utilization rate. It's now at a 14-month high.
  
  
• Retail sales rose 0.3 percent, while "core" sales excluding autos climbed 0.8 percent. Both figures topped estimates.
  
  
• Even consumer credit rose by $5 billion in January, the first monthly rise in a year.

So on TOP of massive budget deficits ... on TOP of the biggest rise in U.S. debt ever ... and on TOP of increasing sovereign credit risk, you have an economic rebound underway. That's going to put even more pressure on bond prices, and help to push interest rates higher.

I think that's especially true now that the Federal Reserve has just weighed in AGAIN with a pledge to keep short-term rates at "exceptionally low levels" for an "extended period." When the economy recovers, the Fed is expected to start normalizing policy. It's not — and it won't do so anytime soon. So I believe the bond market will do it for Chairman Bernanke instead, by driving long-term rates higher!

Some Bond Market Targets

Just exactly what kind of move in bonds do I foresee? Let's put some targets out there!

Long bond futures were recently trading around the 119 price level. I think we're headed to the low 100s by the end of 2010.

What about the benchmark 10-year Treasury Note? The yield there has been hanging out in the 3.6 percent - 3.7 percent area for a while. That won't last. I expect to see the high 4s later this year.

As for other long-term rates, like those charged on 30-year fixed mortgages, they're going up, too. I'd lock in the 5 percent-and-change rates available right now ... before they're gone! You're going to be looking at something in the 6s by this time next year.

Bottom line: The days of cheap, ultra-low rates are behind us. It's time to pay the fiddler!