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Analysis: As economy strengthens, a bonds sell-off may beckon

By Ellen Freilich

NEW YORK (Reuters) - The U.S. government bond market has weakened in recent weeks but some investment strategists fear that this may only be the beginning of an extended sell-off.

They point to the relative strength of the U.S. economy with the labor market stronger than anticipated, retail sales rising and consumer sentiment climbing to its highest level in almost six years. Even the U.S. budget deficit is narrowing at a surprisingly fast pace.

There has been some debate as to whether the stock market is reflecting reality given the 17 percent gains in the S&P 500 to a new record this year. But some prominent strategists say it is the bond market, not stocks, that is out of step with economic conditions.

James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, said the investor confidence that has boosted risky assets like junk bonds and equities will soon lead to a move away from Treasuries.

"I don't think the 10-year will stop at 2 percent. I think it will end the year closer to 3 percent than 2 percent," he said.

However, the primary factor in the equation is the U.S. Federal Reserve's sustained monthly purchases of $85 billion of bonds. Its demand has helped keep interest rates low, if not as low as the record 1.38 percent touched last July.

Fed officials have of late spoken a bit more openly about paring back monthly buying. In testimony to Congress on Wednesday, Fed Chairman Ben Bernanke warned against premature tightening of monetary policy, but he also said "if we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings we could take a step down in our pace of purchases."

"The Bernanke Fed will not be quick to pull back" on its bond purchases, said Joseph Carson, chief U.S. economist at AllianceBernstein in New York, "but if they start to talk about it in the summer and start to taper purchases as early as September, we would put the 10-year Treasury yield at 2.5 percent by the end of this year and 3 percent by the first part of next year."

The U.S. 10-year Treasury note touched 2 percent on Wednesday, selling on those Bernanke comments, putting it about 35 basis points higher than at the beginning of May. Some brokerage firms see it hitting 2.50 to 3.0 percent before the end of the year. (For graphic of US 10-year bond yields http://link.reuters.com/hek58s)

"They do need more time to evaluate whether or not this fiscal drag or the inflation/deflation outlook is going to significantly hinder growth," said Sean Murphy, Treasuries trader at Societe Generale in New York.

Investors are ever-so-slightly starting to take a more bearish view. Large speculators have largely remained on the long side in the bond market since July 2012, but last week they shifted to a modest net short position in 10-year notes for the first time since March, according to Commodity Futures Trading Commission data.

In a note late on Monday, Goldman Sachs said bond yields are the "more distorted asset class," putting the 10-year note's "fair value" at 2.5 percent. They said yields are at least 50 basis points "below their historical relationship with growth and inflation expectations."

The 10-year note has not yielded more than 2.5 percent since August 2011. Analysts estimate that if the 10-year Treasury yield rises to 2.5 percent by year-end, the benchmark note could incur a total return loss of 3.5 percent to 5 percent in that period.

Zach Pandl, strategist at Columbia Management, said the market's growth expectations for the next quarter are still below 2 percent, "and that's below the growth trend we are seeing in the timely data on the economy."

READING THE FED

Consensus among Fed officials seems to have ever-so-slightly moved in the direction of reducing bond-buying. San Francisco Fed President John Williams and Chicago Fed President Charles Evans, both considered "dovish," said the Fed could end its program before year-end if labor markets continues to improve.

But removing monetary accommodation too soon could undermine economic support when world growth remains weak and improvements in the United States may be transitory. New York Fed President William Dudley said on Tuesday that he needed to see how the economy "fights its way through the significant fiscal drag" before deciding on reducing asset purchases.

Also on Tuesday, St. Louis Federal Reserve President James Bullard said the Fed should keep buying bonds, while adjusting the pace of purchases, based on economic data.

"The Fed is just beginning to see what they've been hoping for all along - which is a slightly above-trend pace of economic growth with reasonably strong job creation," said Robert Tipp, chief investment strategist at Prudential Fixed Income in Newark, New Jersey, with more than $1 trillion in assets under management.

"While they could taper purchases in the fourth quarter, for them to signal their intent too early would really be playing with fire."

(Reporting By Ellen Freilich; Editing by Martin Howell)

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