Bond Market: Bull or Bogus?

Three simple words: bonds are back. After suffering through a long dry season during a bull market in stocks and an economic boom, U.S. Treasury bond prices have rallied stirringly in recent weeks. Bond yields move in the opposite direction of prices, and the yield on the benchmark 10-year Treasury note has tumbled from its late-June peak of 5.24% to a five-month low of 4.75% on Thursday.

Money managers around the world have nudged up their bond allocations, according to recent surveys by Merrill Lynch and Reuters. Speculative bets in the futures market that the 10-year note will keep gaining are at record highs, according to the Commodity Futures Trading Commission.

The bond love-fest has been fueled in part by hopes the Federal Reserve has stopped inflation in its tracks. In fact, bond traders may believe the Fed has gone too far in fighting inflation and has put the economy's health at risk. One sign of this belief is that long-term bond yields are well below the shortest of short-term interest rates. Typically, bond investors want higher yields for longer-dated bonds -- unless they expect inflation and interest rates to fall in the future. One way that happens: The economy tanks and the Fed cuts rates.

Not every observer is convinced. Some see irrational exuberance in the bond market and warn a correction is in order. Others believe the Fed has managed the neat trick of taming inflation while also keeping the economy intact -- a "Goldilocks" scenario that will feed runaway stock gains and leave bonds in the dust.

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