The rally in the US bond market that got underway in June 2004 is the fourth bond rally since the 2001 US recession. Unlike the others it was touched off entirely by a string of economic reports that cast doubt on conventional wisdom of a strongly expanding economy with gradually rising inflation. The new view that has shaped the market’s mood is that growth will be a lot weaker next year than predicted a few months ago and that inflation will not rise at all. Naturally the new “wisdom” is itself vulnerable to the flow of data. Indeed, powerful forces are already or soon will be at work to lift US inflation and inflationary expectations: the rebound in oil prices; bubbling housing markets; rising labor costs; and, once the US presidential election is over, a potential policy shift toward a major depreciation of the dollar to deal with the huge US trade deficit.

No one can say that the current bond market rally is about to end today or tomorrow. But it is bound to end by early 2005, if not sooner, as the business outlook for next year crystallizes. Once the bond market’s euphoric mood droops, the reversal in longer-term interest rates is likely to be swifter and more pronounced than the decline in yields since June.

In 2001, the US economy suffered a comparatively mild business recession lasting only eight months, from March 2001 to November 2001. Since the recession trough, the American bond market, as proxied by the yield on 10-year US Treasury obligations, has gone through four significant rallies, as defined by cumulative declines in yields of at least 50 basis points. Each of those rallies had distinctive characteristics, often a mixture of economic and non-economic factors. The latest rally began in mid-June and has been unusual in that it came during a period in which the Federal Reserve raised the Federal funds rate three times, totaling 75 basis points. The last 25 basis point hike was decided this past Tuesday and came after a fairly extensive internal debate within the Fed about whether to keep increasing rates at a “measured pace” or “wait and see” how business conditions unfold. In effect, bond market participants do not agree that the Fed is justified in raising interest rates, because they feel the US economy will be too weak to produce inflationary pressures.

Bond market rallies since 2001 recession

Benchmarked by yield on 10-year US Treasuries