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Bonds Slip as Expectations Grow for Rate Hike

Reuters
Tuesday, 10 Jun 2008 | 4:41 PM ET

U.S. government bond prices fell Tuesday, pushing two-year yields to their highest since January, as inflation fears increased expectations the Federal Reserve would raise interest rates this year to control price growth.

Dallas Federal Reserve Bank President Richard Fishersaid the U.S. central bank would not tolerate rising inflation expectations and that he would accept weaker growth if that kept price rises in check.

Fisher was picking up the inflation baton from Fed Chairman Ben Bernanke, who signaled late Monday that the bank would act strongly to resist an acceleration in price growth while playing down the economy's weakness.

The comments signal that the Fed's period of loose monetary policy to mitigate the effects of turmoil in the financial markets was giving way to higher official interest rates to damp price pressures.

"Everyone was aware that there is an inflation problem but we haven't been concerned about it because of the financial turmoil," said Rick Klingman, managing director of Treasury trading at BNP Paribas in New York.

"If Bernanke thinks the risks to the economy in the second half have improved ... then we might be gradually shifting to worrying about inflation and fighting that fight."

Tuesday's sell-off came after short-dated Treasury yields registered their biggest one-day jump in 25 years on Monday due to the inflation concerns.

The losses were mitigated somewhat by weakness in the stock market, but tough inflation talk from Fed officials took its toll on bonds.

"It's really the overwhelmingly hawkish view from Fisher," Tom di Galoma, head of government trading at Jefferies & Co. in New York, said of Tuesday's market.

Adding his voice to the anti-inflation chorus, Boston Federal Reserve President Eric Rosengren said Tuesday that rising food and energy costs are still trickling through the economy, complicating the outlook for inflation.

Fed rhetoric has had a profound effect on market sentiment, which now anticipates 75 basis points of U.S. interest rate hikes by the end of this year.

This has weighed especially on the front end of the market, where prices fall the most when rate hikes come into play, and narrowed the difference between short- and longer-dated yields.

The spread between 2- and 10-year yields is now at 120 basis points, near its flattest since January.

However, the Fed jawboning appeared to temper market expectations for inflation slightly, based on 10-year inflation-linked bonds issued by the government. The break-even spread narrowed between 10-year nominal bond yields and Treasury Inflation Protected Securities.

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