Deflation warning? Treasury bond yields plunge amid new rush for safety

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Money is pouring into Treasury bonds today, driving yields sharply lower as investors start the fourth quarter with another rush into what they perceive to be safe.

The yield on the 10-year T-note plummeted to 3.20% by about 12:20 p.m. PDT, down from 3.30% on Wednesday and the lowest since May.

The 30-year T-bond yield, charted below, has slumped below 4%, to 3.97% from 4.04% on Wednesday.

Falling market yields mean bond prices are rising. That should give a big boost today to the most popular bond mutual fund, Pimco Total Return, which has been loading up on long-term Treasuries in recent weeks, as detailed by portfolio manager Bill Gross.

The latest bond-buying binge is making individual investors look like they were ahead of the curve: The public has been voracious for bond mutual funds for the last few months even as many Wall Street bulls insisted that stocks were the smarter investment in a recovering economy. Today, stocks are selling off amid fresh concerns about the economy’s ability to sustain a recovery, despite the surprising rise in consumer spending in August. The Dow Jones industrial average was down about 150 points, or 1.5%, to 9,564 at about 12:20 p.m. PDT.

For the bond market -- or at least, high-quality bonds such as Treasuries -- the explosion in demand today suggests an epiphany for many investors who’ve been disbelieving that long-term interest rates could go much lower.

Many bond pros say weakness in key economic data in recent days (including today’s report on U.S. manufacturing activity in September) has raised strong doubts about the recovery.

More investors are sensing that ‘the feel-good bounce in the economy created by the [government’s] fiscal stimulus is not a permanent factor,’ said Tom Tucci, head of Treasury trading at RBC Capital Markets in New York.

That boosts the likelihood that the Federal Reserve will have to maintain near-zero short-term interest rates well into 2010, he said. And if short-term rates aren’t heading higher, investors are more comfortable locking in current yields on longer-term bonds.

Rising tensions between Iran and the West also are encouraging investors to find refuge in the traditional haven of Treasuries, said Tom Di Galoma, head of U.S. rates trading at Guggenheim Capital Markets in New York.

But the biggest factor driving cash into longer-term bonds is the feeling that there is no inflation threat to fixed-income securities, Tucci and Di Galoma said.

In fact, sentiment is shifting more toward the idea that the U.S. could face outright deflation, Tucci said.

Figure it this way: If inflation is 2% and a bond pays 3% interest, the ‘real’ or after-inflation yield is just 1%.

But say inflation turns to deflation, and the U.S. sees broad-based declines in prices of goods and services, similar to Japan’s experience.

At a deflation rate of 2%, the real return on a 3% bond would be 5% -- a huge number, by bond standards.

The deflationistas are still a minority camp on Wall Street. But their numbers will grow if the economic data get weaker instead of stronger.

A big test looms for the bond rally on Friday, with the government’s report on September employment. Wall Street expects that the economy lost a net 175,000 jobs last month. If the tally is larger than that it could spark another rush out of stocks and into Treasuries.

-- Tom Petruno