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Bonds Pressured as Credit Concerns Ease

U.S. Treasury debt prices fell for a third day Thursday as signs of stability in the distressed credit markets caused investors to switch out of safe-haven government bonds.

That improvement, highlighted by weekly data showing a smaller decline in the commercial paper market, made traders scale back their expectations for an interest rate cut of half a percentage point by the Federal Reserve next Tuesday.

"The modest recovery in the markets that have been stressed for over a month might be the reason why Treasuries are lower," said William O'Donnell, head of U.S. interest rate strategy and research at UBS in Stamford, Conn.

Treasurys have tapped a flight-to-quality bid from the upheaval in the credit markets, with benchmark yields falling by about 40 basis points between Aug. 9 and now.

That appeal was reduced as equity prices rose.

Benchmark 10-year notes traded down 18/32 in price to yield 4.48 percent, marking the biggest daily rise in yields for a month. Yields, which move inversely to prices, traded around 4.42 percent late Wednesday.

Two-year notes fell 6/32, yielding 4.06 percent against 3.96 percent late Wednesday.

On Monday, 2-year yields fell as far as 3.82 percent, their lowest since late 2005, in the aftermath of an unexpected drop in August nonfarm payrolls that sparked fears of recession and hopes of a 50 basis point easing by the Fed.

A smaller-than-expected rise in weekly jobless claims and news that the No. 1 U.S. mortgage lender, Countrywide Financial had obtained $12 billion in additional borrowing capacity, also added to doubts of an aggressive Fed easing.

Many now expect the central bank to lower the fed funds rate target by 25 basis points to 5.00 percent next Tuesday.

Fed data showed that the commercial paper market shrank $8.2 billion in the week to Sept. 12, the smallest decline since the start of the credit crunch in early August. The CP market shrank $54.1 billion the previous week.

"A stabilization of the commercial paper market is likely underway. The data could spur a decline in LIBOR," said Tony Crescenzi, chief bond market strategist at Miller Tabak in New York.

Analysts also noted a decline in asset backed commercial paper rates, which they described as the first significant fall since rates started to soar in early August.

"It seems like credit market conditions have started to stabilize somewhat, there have been a tremendous amount of liquidity added to the markets," said UBS' O'Donnell.

The 30-year bond fell 29/32 in price to yield 4.75 percent, versus 4.69 percent late on Wednesday.

Five-year notes dropped 12/32 in price, for a yield of 4.20 percent from 4.11 percent.

Market mood was also darkened by oil prices touching an all-time high above $80 per barrel and the government posting a $116.97 billion budget deficit in August, a record for that month. The budget gap was at $64.72 billion in August last year.

A fairly decent auction of $8 billion worth of reopened 10-year notes did little to ease the selling pressure.

Spreads on two-year interest rate swap spreads tightened sharply to 72.25 basis points from 77.25 basis points late on Wednesday. Ten-year spreads were steady at 65.50 basis points.

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