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A few weeks ago I wrote The Disaster Scenario For Treasury Bonds, which discussed the potential for the 10-year Treasury yield to breakout from its recent range to the upside. I expected that an upside breakout could trigger a fast move up to the 3.50% - 4.00%. The 10-year yield closed the week at 2.83%, but is it a trigger for a sharp move higher or a trap? In this article I will update my analysis of bond market conditions and Federal Reserve policy to assess the potential for higher Treasury bond yields (and lower Treasury bond prices).

10-Year Treasury Bond Yield

The following charts give perspective on the recent movements in the yield on the 10-year (as bond yields rise, bond prices fall).

The yellow box marks the 2.45% - 2.75% range that was recently broken to the upside.

(click to enlarge)

(Note: 28.29, represents a yield of 2.829%, just move the decimal point one place to the left.)

(click to enlarge)

(click to enlarge)

(Source: FreeStockCharts.com)

Bond yields move in the opposite direction as bond prices and the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) is a commonly used proxy for the price of longer dated Treasury bonds:

(click to enlarge)(Source: FreeStockCharts.com)

The ProShares Short 20+ Year Treasury ETF (NYSEARCA:TBF) and ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA:TBT) are designed to move in the opposite direction as the TLT ETF.

The 5-Year and 30-Year Treasury Bonds

It is helpful to look at the 5-year and 30-year for more perspective. Like the 10-year, the yields on these bonds have also been rising. However, the 5-year is still in its recent range, while the 30-year broke to the upside.

(click to enlarge) (click to enlarge)(Source: FreeStockCharts.com)

Shorter term bonds are more anchored to the Fed Funds rate, which the Fed expects to keep at historically low levels for an extended period of time. Therefore, there is more downward pressure on the 5-year than the 10-year or the 30-year.

A breakout on the 5-year above 1.61% (the top of the recent range) would support the argument that the 10-year is headed much higher. However, the yield on the 10-year may be able to start to move higher without the yield on the 5-year making an upside breakout.

Federal Reserve

In my previous article I discussed that the investment community perceived the Federal Reserve as hawkish in May/June and then dovish in July.

It is important to emphasize "perceived" because Bernanke and the Fed have been trying to convey the same message for a while: at some point the Fed will taper (reduce) its $85 billion of monthly bond buying (quantitative easing) and the decision about tapering is dependent on the economic data.

In this context, hawkish means the Fed is leaning toward tapering sooner rather than later.

The following is an update on recent developments since my last article.

Fed meeting on July 30-31:

The post-meeting speeches by Fed officials focused on tapering, but it is not clear there is a consensus about tapering in September. Please note that each of the Fed officials presents his or her own opinion and not the consensus of the committee. These comments from Fed officials were mostly in-line with their previous statements:

The investment community seems to be expecting the Fed to taper at the September meeting:

Going into the last Fed meeting it seemed that market participants were leaning to a perception of the Fed as dovish. Now, it seems that investors are expecting a September tapering.

Regardless of when the Fed actually tapers, the debate about it has led to a higher yield on the 10-year.

The catalyst for the upside breakout in the 10-year yield came on Thursday: Jobless Claims in U.S. Decline to Lowest Level Since 2007.

Demand For Treasury Bonds

In my last article I discussed the perspectives of four types of bond investors and how they may react to higher yields. The four types are: structural investors, retail investors, the bond kings and the Fed.

Structural investors are insurance companies, pension funds, foreign central banks, foreign investors and others who are constantly buying Treasury bonds because of their mandate. They are not as sensitive to yields. Although higher yields mean a decline in the price of their existing bond holdings, they probably welcome the opportunity to buy at higher yields. However, their buying activity over the last few weeks was not enough to drive up Treasury prices and drive down Treasury yields.

Retail investors fled bond funds where rates started to rise a few weeks ago. If the 10-year makes another move higher I expect more outflows from bond funds.

The bond kings are Bill Gross of Pimco and Jeff Gundlach of DoubleLine. They are well respected managers of very large bond portfolios. Earlier this summer they expected the yield on the 10-year to decline. It will be interesting to see if they reverse their position and how they react if there is another major wave of outflows from bond funds.

Already, it seems that Bill Gross and Pimco are slightly changing their view. In July, Bill Gross expected the yield on the 10-year to drop to 2.20%. However, he did not repeat this expectation in his August investment outlook. Furthermore, the August investment outlook suggested that Pimco wanted to avoid duration, which refers to longer dated bonds. Gross prefers short-term Treasuries to long-term Treasuries (source: article about Gross from August 16, see link above). The 10-year is an intermediate-term Treasury and it is not clear if it falls in the camp of bonds to avoid or bonds to buy.

Finally, the Fed has been buying $85 billion of bonds per month, including $45 billion of Treasury bonds. At some point, possibly September, it will reduce the amount it purchases.

In summary, structural investors will continue to buy Treasury bonds, but retail investors, the bond kings and the Fed may represent less demand for Treasury bonds.

At some point, bond yields will rise high enough (and prices low enough) to attract incremental demand. However, I believe that such demand may not come in until the 10-year reaches ~3.5%.

Supply Of Treasury Bonds

A strong argument for those who expect bond yields to drop (and prices to rise) is that the supply of Treasury bonds will shrink. Thanks to a lower than expected deficit, the Treasury will issue fewer bonds.

For more on this, please see:

Other Dynamics For Treasury Bonds

The public speculation about the next Fed chair is another risk for Treasury bonds. Ben Bernanke is scheduled to end his term as Fed chair in early 2014 and President Obama has not yet named a replacement. This dynamic poses several risks for the bond market.

First, there is uncertainty about who will replace Bernanke. The two main candidates are Janet Yellen and Larry Summers. The market may react negatively to the eventual pick.

Second, the Fed is currently relying on two policy tools: quantitative easing and forward guidance (the Fed's expectation to keep the fed funds rate low until unemployment declines). With the likely reduction of QE over the next few months, forward guidance will become more important. However, if Bernanke (and several other members of the FOMC) are going to be replaced then the promises of a lame-duck Fed may not carry as much weight with bond investors.

Another risk for the Fed is the debt ceiling. According to recent projections, the government is expected to reach its debt limit in October/November. This deadline has been pushed out over the last few months, so the government may have some extra breathing room. However, at some point, there will likely be another debt ceiling fight, which could be a negative for the bond market.

10-Year Yield Forecasts

Market strategists are gradually increasing their forecasts for the 10-year yield:

Interesting Relationship Between QE and The 10-Year Yield

Avondale Asset Management recently put together a nice chart that shows that the yield on the 10-year increased during periods of QE, but decreased during periods of no QE -- see What Will Happen to Interest Rates When QE is Over?

Maybe the 10-year yield will follow a similar pattern after this round of QE. But it is important to remember that tapering is not the end of QE, just the beginning of the end. QE may continue through mid-2014.

Also, economic conditions seem different now that during the last periods of no QE, so this pattern may not repeat itself.

Conclusions

The 10-year yield broke out of its recent trading range to the upside. I expected, and continue to expect, this breakout to act as a trigger for a sharp move higher to the 3.50% - 4.00% range.

I expect the 10-year to continue to rise for a few reasons. First, since last summer there has been a trend of rising bond yields and I do not see a catalyst to reverse the trend. Second, the onset of tapering, which marks the beginning of the end of QE, seems likely to drive rates higher. Third, the 10-year still does not provide enough value on a fundamental basis at 2.83%. Fourth, the uncertainty about the next Fed chair and the potential for a debt ceiling debate add risks to the bond market, which could drive up rates.

Despite all the reasons for a higher yield on the 10-year, there is a possibility that the breakout last week was a trap. Dan Fuss of Loomis Sayles talked on Friday about the thin volume in the bond market because of the August slowdown. In this kind of environment there could be a few fakeouts. However, the longer the yield on the 10-year stays above 2.75%, the greater the likelihood of a real breakout.

The yield on the 5-year could be a good indicator for the 10-year. I don't think the yield on the 5-year necessarily needs to breakout for the 10-year to make a sharp move higher, but a higher 5-year yield would give more support to the rising rates argument.

Interestingly, there do not seem to be a lot of people talking about the possibility of a quick move to 3.50% - 4.00% on the 10-year. Everybody knows that rates are rising and will, eventually, move higher, but the consensus seems to be that the move to higher rates will be gradual. Therefore, many investors could be caught off-guard with a quick increase in the yield on the 10-year, which may accelerate the move.

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Source: Disaster Scenario For Treasury Bonds: Is The 10-Year At 2.83% A Trigger Or Trap?

Additional disclosure: I may trade any of the securities mentioned in this article at any time, including in the next 72 hours.