US Bonds Market Suffers Worst Month Since December 2010

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U.S. Treasury debt prices slipped on Friday, capping the worst month for the market in nearly 2-1/2 years, as stronger-than-expected business activity data fanned worries the Federal Reserve might slow its bond purchases later this year.

As prices slid, Treasury yields retested their highest levels in more than 13 months, set two days earlier, even though data signaled inflation remained low due to sluggish growth.

It was unclear whether Treasurys prices have bottomed as investors sharply scaled back their bond holdings on worries that reduced Fed stimulus will cause long-term borrowing costs to rise, marking the beginning of the end of quantitative easing (QE) that the Fed adopted in late 2008.

"It's all about the Fed, and how do we get back to fair value after QE," said Gemma Wright-Casparius, portfolio manager at Vanguard in Malvern, Pennsylvania.

(Read More: Rising Yields May Stifle Boom in Dividend Stocks)

Traders are now grappling with whether the Fed may end bond purchases on a stronger economy, or if it might also choose to end buybacks as stocks and housing prices surge even if the central bank fails to achieve its objective of lowering the unemployment rate to 6.5 percent.

At his congressional testimony last week, Fed Chairman Ben Bernanke said a decision to pare the Fed's current pace of bond purchases may happen at one of Fed's "next few meetings" if the economy looked set to maintain momentum.

However, U.S. inflation, which is running well under the Fed's target of 2 percent, may complicate the Fed's ability to taper its current $85 billion monthly purchases in Treasurys and mortgage-backed securities, commonly called QE3.

"The thing Bernanke cares about preventing the most is deflation first and severe disinflation second, so I suspect that if inflation readings remain very low it's going to make him want to keep on purchasing at the current pace of $85 billion and not even think about tapering," said Michael Schumacher, head of global rates strategy at UBS in Stamford, Connecticut.

Still most investors and traders were clearly unnerved by the possibility of the Fed tapering earlier than they had expected, which was at least into the end of this year.

The Treasuries market as a whole has fallen 1.58 percent through Thursday, putting it on track to record its biggest monthly loss since December 2010, according to an index compiled by Barclays.

(Read More: Goldman: This US Treasury Sell-Off Is for Real)

On the open market on heavy volume, benchmark 10-year notes were 4/32 lower in price to yield 2.134 percent on Friday, after earlier trading as low as 2.066 percent. The 10-year yield reached a 13-month high of 2.235 percent on Wednesday, and has surged from around 1.61 percent at the beginning of May.

The 30-year bond finished up 4/32 at 92-13/32 in late trading. The 30-year yield earlier rose to 3.356 percent, about 1.5 basis points below its 13-month-plus high set two days earlier.

Volume, Volatility Jump

While Bernanke's remarks sparked the latest leg of the market sell-off, it began earlier this month after a stronger-than-expected April payrolls report.

The market decline was driven by heavy volume in the cash and futures markets in a holiday shortened week.

As of 4 p.m., $640.2 billion in Treasuries had changed hands, 66 percent above its 20-day moving average, according to ICAP, the world's biggest inter-dealer broker for U.S. government bonds. This was the second day this week that more than $600 billion in Treasuries traded, according to ICAP.

The spike in bond yields this week sent implied volatility measures in the options market to the highest level since July, analysts said.

The next catalyst for investors will be next Friday's payrolls employment report for May, which traders expect will determine whether rates have more room to move higher, or if the recent selloff is overdone.

"If you get the hint or the idea that they're going to start to trim purchases then this is the volatility that's going to be created around it," said Sean Murphy, a Treasurys trader at Societe Generale in New York.

Friday's action showed the wild swings that have become a common feature in the current market sell-off.

Bond prices gained early as more investors bet the recent selloff may be done, covering short positions and as month-end buying also boosted bonds.

Those gains were supported by data that showed meager consumer spending and price growth in April. The core personal consumption expenditure index, the Fed's preferred inflation gauge, slowed to 1.1 percent, its weakest year-over-year pace since March 2011.

They reversed course, however, after the Institute for Supply Management-Chicago business barometer rose to 58.7 from 49 in April, handily beating economists' expectations for 50.

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