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Short-Dated Bonds Benefit From Economic Weakness

Reuters
Thursday, 3 Jul 2008 | 12:07 PM ET

Short-dated U.S. government debt prices edged up Thursday, as weak data reinforced a grim view of the economy and pared expectations that the Federal Reserve will raise interest rates any time soon.

Traders also anticipated, however, that a steady Fed monetary policy will be inflationary down the road, as oil and food prices continue advancing into record territory. They dumped long-dated Treasurys in favor of shorter maturities which are less sensitive to inflation.

"It smells like stagflation. That's why you have the yield curve steepening," said Tom Sowanick, chief investment officer at Clearbrook Financial in Princeton, N.J.

Earlier Thursday, the European Central Bank as expected lifted benchmark euro zone rates by a quarter percentage point to 4.25 percent in bid to combat inflation in the region, which hit record highs in June.

The perceived decreasing likelihood of an imminent Fed rate hike bolstered the stock market which has been bruised by record oil prices, which nearly reached $146 a barrel, and news of more bank losses and write-downs. This curbed the safe-haven appeal of Treasurys.

The price on two-year Treasury notes, the maturity most sensitive to the market's Fed outlook, rose 2/32 to 100-20/32. Its yield, which moves inversely to its price, was 2.55 percent, down 2.58 percent from late on Wednesday.

The benchmark 10-year Treasury note's price slipped 3/32 for a yield of 3.97 percent versus 3.96 percent late Wednesday.

The gap between two-year and 10-year note yields, which grows with inflation expectations, was last 143 basis points versus 138 basis on Wednesday.

Trading was choppy as the bond market will close early at 2 p.m. ahead of the July 4 U.S. Independence Day holiday. The market will be shut Friday.

Fed in a Bind

While the ECB took a decisive step to try to prevent a crippling wage-price inflation spiral, the Fed remained in a quandary because of its dual mandate to both promote growth and contain inflation, analysts said.

Euro zone debt prices rose and outperformed Treasurys after the ECB rate decision.

ECB policy-makers "are the only ones stepping up to the plate to back up their anti-inflation talk," said Lindsey Piegza, market analyst at FTN Financial in New York.

"The Fed on the other hand will be forced by the economy and the market to remain unchanged. There is just too much downward pressure on the economy at this point," she said.

U.S. employers shed jobs for a sixth straight month in June, bringing year-to-date job losses to 438,000. The labor market picture looked bleaker as jobless claims last week shot up above 400,000, a level tied to past recessions.

Moreover, the Institute for Supply Management's service sector index posted a bigger-than-expected drop last month. The surprise contraction in the vital sector led traders to pare their outlook for a Fed rate increase in the coming months.

In other cash trading, five-year notes were up 2/32 in price to yield 3.28 percent, down from 3.30 percent late on Wednesday, while the 30-year long bond was down 21/32 for a yield of 4.55 percent, up from 4.50 percent late Wednesday.

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