Analysis: What's upset bond market so much?

Sure, new data showing signs of economic improvement haven't pleased bond investors, who worry that a recovery will lead to higher interest rates -- something that would crimp their returns.

But there is more to this sell-off than that. This market has overwhelmingly come under the grips of technical factors, which makes its next move even tougher to figure out.

The market's downward slide began two months ago, after stunning gains in late spring sent prices surging and long-term Treasury yields -- which move in the opposite direction to prices -- sinking to 45-year-lows of 3.11 percent in June.

That rally, built on a market that has been surging for two years, was largely set off after the Federal Reserve's May statement about a potential deflation threat.

Fed officials subsequently commented that the central bank was not only prepared to push interest rates lower but also was ready to use "unconventional" methods to influence interest rates, such as buying Treasury securities.

Adding to the gains was massive buying by holders of mortgage-backed securities, who were loading up on 10-year Treasuries to hedge fluctuations in their portfolios caused by the home refinancing boom. In addition, foreign buying of Treasuries helped prop up the market.

But the party abruptly ended in late June, and the bond market quickly reversed its course.

Long-term yields now trade around 4.5 percent, with much of that gain coming in July. The corresponding drop in price made July the worst month for returns in at least 75 years, according to Morgan Stanley market strategist Steve Galbraith.

Often cited for causing much of this pullback has been the improving economic outlook, with a spattering of recent data pointing to a pickup in growth. That has spooked bond investors, who fear interest rates will soon move higher as the Fed looks to temper growth. And when rates rise, anyone who has to sell their bonds before they mature loses out.

But Merrill Lynch's chief North American economist, David Rosenberg, challenges the idea that the economic backdrop has shifted enough to fuel this kind of sell-off.

Rosenberg points out that since June, the consensus on Wall Street has only increased the economic growth forecast for 2004 by 0.1 percent to 3.7 percent.

So what's got this market so bothered?

The disillusionment began after the Fed's late-June policy-making committee meeting, where short-term interest rates were cut by less than many investors had hoped based on the comments Fed officials had made during the preceding month.

Then in mid-July, Fed Chairman Alan Greenspan hinted during his testimony to Congress that buying bonds wasn't on the Fed's agenda.

That launched the massive sell-off, as investors who had counted on lower rates got out. And as the market deteriorated, other technical problems erupted.

Those holders of mortgage-backed securities now faced an environment where rates were rising, causing refinancing to slow and the average life of mortgages to grow. So just as they bought Treasurys to balance risk in their portfolios, they now had to sell to do the same.

Investors yanked $3.43 billion out of government bond funds investing in mortgage-backed securities in July alone and another $2.6 billion so far this month through Aug. 20, according to AMG Data Services.

"All this set off like a domino effect," said Sharon Stark, chief fixed income strategist at Legg Mason Wood Walker. "And it continues to create a lot of volatility in the market."

Now the question is what will happen next. Market-watchers say that may rest largely on how long these technical factors stick around.

Some, however, still hope that the selling momentum will slow.

Zane Brown, director of fixed income management at Lord Abbett, says the 10-year Treasury yield historically reflects the current rate of inflation, plus 2 percent to 3 percent.

That puts a range on the Treasury yield at 3.5 percent to 4.5 percent, about where it is trading now.

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