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Bonds Gain as Investors Scurry For Safety

U.S. Treasurys rallied Wednesday as stock losses, higher crude oil prices and rumored investment banking losses spurred a bid for safe-haven government debt after a two-day retreat.

Meanwhile, prospects for Federal Reserve rate hikes this year dwindled, but fed funds futures contracts still reflected expectations for a 25-basis-point increase by October.

Equity losses were particularly pronounced in the financial sector where the S&P 500 financial index briefly hit a five-year low on rumored Goldman Sachs write-downs. Goldman said that it does not comment on market rumors.

The battering that Treasurys took early in the week, one that pushed two-year yields (which move inversely to prices) up to their highest level since January, put them at levels attractive enough to draw buyers, analysts said.

James Caron, head of global rates research at Morgan Stanley, said the unwarranted pricing in of Fed rate hikes this year had left two-year Treasury note yields "very, very cheap" relative to where Fed monetary policy is actually headed.

"The Fed will stay on hold (until 2009) and, therefore, I would buy two-years here," he told reporters at the Reuters Investment Outlook Summit in New York on Tuesday.

After a two-day sell-off, Treasurys were technically oversold and due for some rebound, said William Sullivan, chief economist at JVB Financial Group in Boca Raton, Fla.

"The combination of the oversold condition, the weakness in equities, the run-up in energy prices, and rumors - even if they're false - created a mini-flight-to-quality," he said.

Two-year notes rose 8/32 in price as their yield eased to 2.79 percent from 2.93 percent late on Tuesday.

Near the long end of the maturity range, benchmark 10-year notes climbed 15/32 in price as their yields eased to 4.04 percent from 4.10 percent late Tuesday.

The buying also caused the yield curve to re-steepen a bit as the difference between two- and 10-year yields widened.

Recent anti-inflation rhetoric by Fed and foreign central bank officials has especially weighed on short-term Treasurys, where prices fall the most on talk of rate hikes.

That dynamic shrank the difference between two- and 10-year yields to 120 basis points Tuesday, from 154 basis points Friday when the bond market rallied on an unexpectedly sharp jump in the U.S. unemployment rate.

On Wednesday, however, European Central Bank officials suggested markets might have interpreted their recent anti-inflation talk too aggressively and euro-zone market interest rates softened.

That helped the U.S. Treasury market in early dealings, said Thomas di Galoma, head of U.S. Treasury trading at Jefferies & Co. in New York.

The more tempered view of prospective rate hikes widened the difference between two- and 10-year yields to 124 basis points near midday on Wednesday from 120 late Tuesday.

Markets hear from more Fed speakers on Wednesday. On Tuesday, Dallas Fed Bank President Richard Fishersaid the Fed would not allow inflation expectations to rise unchecked and that he would accept weaker growth if needed to keep inflation low.

Fisher's remarks were similar to the hard line taken in a speech on Monday evening by Fed Chairman Ben Bernanke, who said that rising energy prices were pressuring inflation and that the central bank would strongly resist any tendency for an inflationary psychology to take hold.

The comments had a profound effect on the bond market.

Over Monday and Tuesday's sessions, two-year notes had their biggest two-day rise in yields in 26 years.

Fed Vice Chairman Donald Kohn's remarks Wednesdaythat a steady rise in energy prices had fueled an inflationary psychology and could be a problem if it does not reverse seemed to mesh with the views of Fisher and Bernanke.

U.S. Treasurys bounced higher on Wednesday as investors questioned whether global bond markets, after two days of dramatic falls, had gone too far in factoring in interest rate hikes.

European Central Bank officials suggested markets might have interpreted their recent anti-inflation talk too aggressively.

ECB Executive Board member Juergen Stark was reported as saying the European Central Bank is not talking about a series of interest rate hikes.

ECB Governing Council member Christian Noyer seemed to echo this sentiment when he said that market expectations for the path of euro-zone interest rates after summer are not necessarily justified.

The softer tone on rates from Europe comforted some U.S. bond investors, who had been unnerved by hawkish Federal Reserve rhetoric this week.

"The ECB's Stark said the European Central Bank is not talking about a series of rate hikes. That seemed to temper the fears of rate hikes in Europe," said Thomas di Galoma, head of U.S. Treasury trading at Jefferies & Co. in New York.

"That's what has helped our market."

Two-year notes, the most sensitive to changing views on Fed interest rate policy, rose 7/32 in price, pushing the yield down to 2.80 percent from 2.93 percent late on Tuesday.

Price drops during Tuesday's session pushed two-year yields up as far as 2.97 percent, their highest since January.

Benchmark 10-year notes gained 9/32 in price, pushing yields down to 4.06 percent from 4.10 percent late on Tuesday.

Five-year notes gained 13/32 in price, pushing yields down to 3.47 percent from 3.56 percent.

The 30-year long bond gained 3/32, yielding 4.69 percent.

Markets will have another chance to reassess the recent Fed rhetoric with a series of central bank officials due to speak later on Wednesday.

On Tuesday, Dallas Fed Bank President Richard Fishersaid the Fed would not allow inflation expectations to rise unchecked and that he would accept weaker growth if needed to keep inflation low.

Fisher's remarks were similar to the hard line taken in a speech on Monday evening by Fed Chairman Ben Bernanke, who said that rising energy prices were pressuring inflation and that the central bank would strongly resist any tendency for an inflationary psychology to take hold.

The comments had a profound effect on the bond market. Over Monday and Tuesday's sessions, two-year notes saw their biggest two-day rise in yields in 26 years.

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