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Bond bubble may be closer to popping

March 12, 2013: 12:31 PM ET
Long-term Treasury yields are back above 2% -- and this may be just the beginning of a steady grind higher.

Long-term Treasury yields are back above 2% -- and this may be just the beginning of a steady grind higher.

The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, Abbott Laboratories and AbbVie, La Monica does not own positions in any individual stocks.

The Dow is at a record high and the S&P 500 is thisclose to joining its blue chip brother. But as investors become more and more giddy about stocks, bonds have suffered collateral damage.

The yield on the 10-year U.S. Treasury note is currently hovering at a level just north of 2%. While that's still extremely low by historical standards, it's an 11-month high. And yields, which rise when bond prices fall, were as low as 1.56% as recently as early December. So bonds have sold off pretty dramatically in a period of three months ... the same time stocks have surged.

As long as the U.S. economy continues to show gradual (albeit tepid) signs of improvement, investors will likely continue to buy more stocks and start to sell more bonds since there is no need to act as conservatively.

Now, there is no reason for panic in the bond market disco yet. But this could be the beginning stages of the bond bubble finally starting to burst.

"While not yet the end of the world, the 2%-2.1% range has marked the top end of a year-long trading range for Treasury bonds," Dearborn Partners managing director Paul Nolte wrote in a recent note. In other words, if the 10-year is finally able to bust through 2.1%, it may have no problem heading higher.

Related: Is it too late to get in on Pimco's bond ETF?

But what about the Federal Reserve? Isn't it still committed to keeping rates low? And aren't investors taught not to fight the Fed?

Well, the Fed may have done all it can at this point. Nolte noted that "economic growth, erratic as it is, is likely to impact the bond market well in advance of the Fed deciding to pull liquidity from the system and begin a campaign of raising rates."

Some of the more inflation-obsessed members of the Fed have already been calling for the central bank to start thinking about pulling back on the extraordinary stimulus measures that have been in place since the financial crisis four years ago.

And while it's unlikely that the Fed will make any major policy changes anytime soon -- Fed chairman Ben Bernanke and vice chair Janet Yellen are still more worried about the sluggish labor market than inflation -- it seems safe to say that the Fed is not going to increase its quantitative easing bond buying program either.

Related: Fed's Yellen wants return to 'prudent risk-taking'

That means that long-term rates should keep climbing. In a report Tuesday, Columbia Management senior interest rates strategist Zach Pandl wrote that "the Fed's unconventional monetary policy isn't aging well — bond yields will rise without new stimulus."

Pandl estimates that the yield on the 10-year Treasury could rise 5 basis points, i.e. 5/100 of a percent, each month unless the Fed announces more easing. That may not sound like a lot. But do the math and it adds up. If Pandl is right, the 10-year would be yielding around 2.6% in about a year and 3.2% in early 2015.

That's still pretty low, but it might be high enough to cause a big shock to bond investors who've bet rates would stay below 2% indefinitely. It could also wreak havoc on the housing market since mortgage rates would likely climb. Even if a spike in long-term rates doesn't lead to a big drop in new home buying, it could kill the refinancing boom. That could be bad news for banks.

And who's to say that rates would only rise gradually? There are other reasons to expect that bond yields could spike dramatically higher.

For one, the Bank of Japan now appears to be the new Fed. Japan is talking about aggressively easing in order to weaken the yen and boost exports. That should help strengthen the U.S. dollar.

Related: High hopes for Japan's new top central banker

Continued political instability in Europe may pressure the European Central Bank to lower interest rates soon as well. That too could boost the greenback.

The U.S. Dollar Index, which tracks the value of dead presidents versus a basket of other key currencies, is already up more than 3% this year and is near a 52-week high. And as a general rule of thumb, a stronger currency is usually accompanied by higher interest rates.

Finally, there's the woeful state of U.S. politics to consider. If Congress and President Obama are unable to come up with a reasonable plan to cut spending, reform taxes and reduce the nation's federal debt load, then the U.S. risks another credit rating downgrade.

And if our nation's least and dimmest (can I trademark that along with barbecue recovery?) fail to reach an agreement on raising the debt ceiling by mid-May, it's all but certain that at least one (if not more) ratings agency will cut the U.S.'s. credit rating. That would likely lead to a further increase in long-term rates. The bond market may have brushed off the S&P downgrade of the U.S. in August 2011, but it can't blissfully ignore the discord in Washington forever.

Sure, the U.S. is not Greece. It's not even Italy or Spain for that matter. But it's not Germany either. The U.S. is no longer the safest of safe havens.

Add that all up and it's hard to envision a scenario where bond yields stay this low. The bubble may not violently burst like it did with dot-coms in 2000 and housing prices and bank stocks in 2008. But it won't be pretty.

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Paul Lamonica
Paul R. La Monica
Assistant Managing Editor, CNNMoney

Paul R. La Monica is an assistant managing editor at CNNMoney. He is the author of the site's daily column, The Buzz, and also tweets throughout the day about the markets and economy @LaMonicaBuzz. La Monica also oversees the site's economic, markets and technology coverage.

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