“The recent, rapid improvement in the U.S. economic outlook has sent waves through the bond market, driving key interest rates higher, punishing flat-footed investors and sapping the home-mortgage business,” writes Aaron Lucchetti in today’s Wall Street Journal.

“Yesterday, the market yield on the bellwether 10-year U.S. Treasury note climbed to 4.37%, up from 4.35% a day earlier and sharply higher than the 3.7% it yielded only a month ago. Since the rates that borrowers pay on many loans, including trillions of dollars in mortgages, auto loans and credit cards, are tied to that rate or short-term rates targeted by the Federal Reserve, Americans with adjustable-rate loans soon could see their monthly payments rise. Others looking for a new mortgage loan will have to dig deeper into their pockets to cover rising interest costs.”

“On Wall Street, the steep changes in the market already are being felt: Bond prices move inversely to their yields, which means that the value of bond holdings has been eroding steadily in the last month. Yesterday, the 10-year note fell 5/32, or $1.56 per $1,000 face value. About $25 billion has been lost this month alone in Treasury bonds, not including shorter-term notes or more volatile corporate bonds, according to Bianco Research, a Chicago research firm.”

“The losses aren’t yet huge, and indeed many investors had anticipated a rise in interest rates. The largest bond mutual fund, Pimco Total Return Fund, has seen its portfolio value decline 1.6% since the beginning of the quarter through Tuesday, resulting in losses of about $1.2 billion, according to fund researcher Morningstar Inc. In recent filings, Pimco Total Return had $74 billion in assets.”

“Still, the quick move has erased about 4% of the value of long-term Treasury bonds in less than a month. Market participants worry that the upward trend in rates, and downward move in prices, could accelerate if big investors with sophisticated ‘hedging’ strategies decide to try to protect themselves by selling U.S. Treasurys. Some, such as Fannie Mae and Freddie Mac, government-chartered institutions that trade in home loans, hold large swaths of volatile mortgage-backed bonds that can be hedged through transactions involving Treasurys. A sign that the bond-market turmoil is stirring things up: Big mortgage players sold about $3 billion in mortgage bonds on Tuesday alone, about double the normal daily volume, one analyst said.”

“Because of the bond market’s size — there are about $3.5 trillion in U.S. government bonds outstanding, and trillions more in dollar-denominated bonds issued by companies and government agencies — sudden shifts can have important repercussions. In 1994, rapid increases in short-term rates by the Federal Reserve caused losses on bond desks across the country, and in 1998, many bonds plummeted and trading in parts of the bond market froze up after the investment fund Long-Term Capital Management had to unwind massive bets that had gone bad.”

“What has set the bond market on edge this week is a spate of good news for the U.S. economy. Employment and consumer spending have rebounded in recent weeks, and yesterday the Labor Department said consumer prices excluding food and energy climbed more in March than they had in any single month since 2001.”

“In large part, the bond market is moving in anticipation that the Federal Reserve will try to head off percolating inflationary pressures by raising its target for the interest rate banks charge each other on overnight loans, perhaps as soon as August. By setting those rates higher, the Fed can constrain borrowing.”

“The magnitude of the bond market’s reaction to recent economic reports may have surprised the Federal Reserve, though Fed officials are likely to see the sharp move in bond prices as logical and, perhaps, even helpful. As the economy strengthens, higher long-term rates will help do the Fed’s job of preventing demand from overheating and pushing inflation up higher than it would like.”