As the Economy Turns

Treasury rates spiked higher today as economic data convinced a few more people that US economic growth might surprise to the upside. If the US Labor Department monthly jobs report due out this Friday materially exceeds expectations, we could be on our way to a 4% 10 year note yield over the next couple of months. The entire Treasury yield curve moved about 13 bps higher today, with the 10 year still inside of recent support at 3.5% but well above the 2.8% from only about a month ago. That support implied a bit of skepticism about the strength of the recovery, with traders willing to buy when rates got to that level, but confirmation of a stronger than expected labor market would be a game changer that would reset the range on interest rates.With the unemployment rate still uncomfortably high at north of 9% and monthly payroll reports from the US Labor Department stubbornly failing to deliver sufficient gains, many traders and investors have been willing to buy Treasuries on dips prior to today. There's a reason why unemployment benefits keep getting extended. Some would say we have a structural employment problem, as the crash of the housing boom and the structured credit bubble left a black hole in our economy with lots of jobs permanently lost.We've all been waiting for the labor market to turn around to provide the income needed to stimulate consumer spending and get the economic cycle going in a favorable direction. The ADP private payroll survey released today, printed at an off the charts +297k today while the Challenger, Gray and Christmas survey reported 29% less layoffs than December a year ago. All of that bodes well for the monthly US Labor Department report this Friday and Treasuries repriced to reflect that risk. Also encouraging was a stronger Service sector report from the ISM (Institute of Supply Management). The housing market is still in a problematic condition and rising rates could slow down the recovery. Also a drag on growth are mounting budget deficits and debt levels for many of our largest States that should lead to layoffs in the public labor sector. Those dampeners should contain growth and inflation enough to keep 10 year yields south of 4% for a while and there is substantial technical support as well. Corporate bonds should outperform, especially high yield and emerging market bonds, as improving corporate profits provide support to balance sheets and commodities markets remain strong, fueled by stronger economic growth. One other concern for investors in higher risk credit products is the European sovereign debt crisis, which has derailed rallies in the past and will likely provide the occasional pothole in the coming year. Investors fear a larger banking crisis overseas but negative headlines will prove to be buying opportunities as they were this past year. As the US economic recovery gains steam that should help European nations as tourism rises and US consumption of their exports increases. Getting from point A to point C has always required going through B first and point B involves major structural changes in the Southern European economies as well as a possible debt restructuring for Greece and asset write downs for banks that hold the debt of other troubled nations that could cause significant but manageable losses for the system as a whole. The bottom line is that certain sectors of the bond market may provide decent returns this year despite rising Treasury rates.