Bond Market Profile

The long term bull market in bonds remains in place.

The most recent downtrend in yields, which began around
mid-2004, also remains in place, although the market is
overbought for the very short run.

At 4.40%, the long Treasury is discounting a return of
inflation to 1.5-2.0%. Moreover, there has been some
slight shrinkage in the longer term volatility premium
as well.

With the CPI now at 3.1% yr/yr, the market is running
entirely on forecast and expectation. Viewed historically,
this is very unusual behavoir for this market.

The forecast/expectation is that the combination of rising
short rates and fuel prices coupled with a tightening of
basic monetary liqidity will be sufficient to produce
enough economic slack to return inflation to 1.5-2.0%.

The market is likely also forecasting that oil and gas prices
will ultimately retreat markedly from levels seen as well
above reasonable. This seems a fair assumption since
continued significant strength in fuels will eventually
infect popular "core" inflation readings as producers and
service providers move to raise prices as they can to
protect operating margins.

Market players are also clearly chasing yield. Even though
the expectation is of a slow economy ahead, Medium grade
corporate credits have also rallied from the 7.0% level
seen in Q2 '04 to 6.45% recently. So, there has been but
a minor widening of spreads between Treasuries and lesser
quality investment grade corporates.

Advisory sentiment as measured by Market Vane is too bullish
but not at the extreme levels seen in the past quarter,
when the measure registered 77% bulls.

This is all heady stuff, particularly the willingness of
bond players to forecast the future with such confidence.

The market leaves me edgy. I am not used to seeing the bond
market look so far out in time with such confidence, and as
discussed in the prior post, it appears to me that the Fed
does not have as full control of the situation as the market
may think.