What the Dow's Plunge Means for Bonds

You can blame today's big drop in the Dow Jones Industrials (INDEX: ^DJI) -- at 160 points and counting as of 1:45 p.m. EDT -- on several things, ranging from European fears and the Federal Reserve's announcement yesterday to simply a tired market that's soared so far this year. But an equally important question for many investors is what impact the Dow's plunge will have on the bond market.

In recent months, the Dow's rise has come at the expense of bonds. The 10-year Treasury yield (INDEX: ^TNX) has risen from 1.87% at the beginning of 2012 to as high as 2.4% last month, as improving economic conditions seemed to hint at a coming end to the Fed's low rate policies. The jump in the 30-year Treasury yield (INDEX: ^TYX) was even more extreme, with rates rising from 2.89% to 3.49% at their highs last month. Yet throughout this period, short-term rates have hardly budged, with three-month Treasury bills staying under 0.1%.

But over the past two days, we've seen the bond market react differently to the Dow's drops. Yesterday, bond yields rose even as stocks fell, with expectations that the Fed would let rates rise, driving the stock market's decline. Today, though, bond yields are moving back down, presumably as investors look for safe havens to protect themselves from a stock market correction.

Meanwhile, European problems could have a direct impact on bonds. It was a poor auction of government debt from Spain that helped reawaken fears of a sovereign-debt crisis, and those problems could well persist for quite a while. Already, both Banco Santander (NYS: STD) and National Bank of Greece (NYS: NBG) are close to revisiting their recent lows as a result of those fears, and even French banks are coming under pressure. So far, U.S. bonds have been largely unaffected, but a full-blown financial crisis would likely push investors into the perceived safety of Treasuries even as European bonds lose value.

What's next for bonds depends a lot on how the economy plays out. A stronger recovery should boost rates. But any unexpected weakness could bring rates back down, making money for bond investors.

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