Bloomberg is reporting U.S. Notes Have Longest Rally in 5 Years on Demand for Safety.

U.S. two-year Treasuries headed for their longest rally in five years as tumbling stocks and credit- market losses increased demand for the relative safety of government debt. Two-year yields fell below 3 percent and 10-year yields declined to less than 4 percent this week, both levels unseen since 2005.

The last time notes had such a long run of gains was in the period ended Oct. 4, 2002. The Fed was in the process of cutting its target for overnight loans between banks, bringing it to a 45-year low of 1 percent by June of 2003.

My Comment: We can easily be in for a repeat performance.

Futures contracts on the Chicago Board of Trade showed a 90 percent chance the Fed will lower its target rate a quarter- percentage point to 4.25 percent next month and 77 percent odds of a further cut to 4 percent in January. The central bank has cut the rate by three quarters of a percentage point this year to 4.5 percent.

My Comment: If the December jobs report is weak, the Fed will at least change its bias towards easing. But a cut would be more likely. The bigger the jobs disaster the bigger the cut may be.

“They’re extremely overvalued,” said Felix Stephen, who helps oversee the equivalent of $7.69 billion at Advance Asset Management Ltd. in Sydney. “This is a recipe for more growth.” Advance Asset has positions that will benefit if Treasuries fall, he said.

My Comment: Felix Stephen is smoking strong stuff if he this we are headed for strong growth.

“Do not, we repeat, do not believe for a second that this is a healthy steepening of the yield curve,” wrote David Rosenberg, Merrill’s New York-based chief North America economist, in a research report. “The Fed is keeping the funds rate at 4.5 percent at a time when every single other maturity out the curve is trading lower in yield.”

My Comment: Bingo.

Two-year yields will climb to 3.71 percent by year-end, according to a Bloomberg survey of economists, with the most recent forecasts given the heaviest weightings.

My Comment: I am amazed by that survey. What the heck are those economists possibly thinking? Stranger things have happened I suppose, but that is an extremely poor bet. In fact, if jobs come in exceptionally week, 10 year yields could drop to 3.75 or so.

It would take a huge jobs number to cause a treasury selloff like that predicted by the economists survey. In addition, mortgage rates will soar should that happen.

Yield Curve As Of November 23 2007

click on chart for a crisper image

It is always dangerous to make specific predictions in a specific timeframe but I am going to give it a shot. The line in blue above is what I think the curve will look like if the next jobs report comes in weak. Since I do expect weak jobs, I expect a further rally in treasuries then a year end selloff to perhaps back where we are now.

On a reasonable jobs report I expect a near term selloff then a rally back to where we are now. In no cases do I foresee a pronounced shifting of the entire curve up or a steep selloff in the 2 year note.

Mike Shedlock / Mish
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