U.S. Treasury debt rallied on Friday as underlying inflation retreated, but the bond market still posted its worst quarter in over a year.
Investors were encouraged by a decline in a key measure of inflation, which fell beneath the top of the Federal Reserve's 1 percent to 2 percent comfort range for the first time in three years.
While not enough to convince the market that the central bank would stand ready to cut rates, the data did not appear to give officials any reason to raise them either.
"If, indeed, inflation continues to moderate and stay within that zone then we lose pressure on the Fed to tighten monetary policy," said Kevin Logan, economist Dresdner Kleinwort Wasserstein.
Relieved by the figures, benchmark 10-year notes jumped over half a point in price and were offering a yield of 5.04 percent, down from 5.11 percent on Thursday.
Traders also cited the discovery of a car bomb in London, which police defused, as generating safe-have demand for government debt. Investors were also generally worried about ongoing credit concerns, with fears of a crunch rising.
Ten-year interest rate swap spreads -- one gauge of investors view of riskier assets -- widened to 63.75 basis points late on Friday, nearing their widest levels since 2003.
Widening swap spreads tend to signal growing risk aversion. Some cautioned the bond rally could be short-lived, however. They pointed to the Fed's statement on Thursday following its two-day meeting, in which policy-makers sought to distance themselves from the idea that a decline in core inflation measures alone would be enough to trigger lower rates.
Still, with stocks struggling in negative territory, Treasuries seemed like the easy alternative, with two-year notes <US2YT=RR> surging 4/32 for a yield of 4.89 percent.
Looking back on the second quarter, though, the charts painted a different picture. In a three-month period that witnessed a drastic recalibration of interest rate expectations worldwide, Treasuries suffered heavy losses along with the government bonds of other developed nations.
Ten-year note yields, which move inversely to their price, posted their biggest one-quarter spike since the first quarter of 2006.
Things did brighten up for the market as the quarter drew to a close. Worries surrounding wayward investment in subprime mortgages, and the near-collapse of two Bear Stearns hedge funds in particular, boosted risk-aversion and rekindled interest in bonds.
It remains to be seen whether the late-quarter bid can be sustained. Much of that will depend on the level of contagion from subprime mortgages on the rest of the housing sector, and eventually, on whether consumers and businesses have enough cash on hand to keep the economy chugging along.
Other bits of data on Friday offered mixed clues on that count. Midwest business activity slowed but held at solid levels. Meanwhile, consumer confidence slipped to a 10-month low, suggesting Americans are being worn down by high gasoline costs and falling house prices.