Bonds Higher as Fears of Rate Hike Subside

U.S. Treasury prices rose Friday after a contained reading of core consumer prices alleviated some bond market fears that global inflation pressures could soon force the Federal Reserve to hike interest rates.

A report showing U.S. consumer confidence tumbled more than expected in June, hitting another 28-year low, underscored the enfeebled state of the economy and contributed to bond investors paring back some bets for rate increases this year.

Headline CPI accelerated to 4.2 percent year-over-year in May from 3.9 percent in April, but the core reading, which excludes food and energy remained at 2.3 percent year-over-year.

The two-year Treasury note's price rose 8/32 for a yield of 2.92 percent, versus 3.05 percent late Thursday.

"There is a bit of a relief rally in Treasurys. It looks as though the secondary effects of the oil price shock are not affecting the core. It seems less urgent for the Fed to move rates higher," said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ in New York

U.S. short term interest rate futures pruned back the implied chance of a 25 basis point rate increase at the central bank's June policy meeting to about 14 percent after the inflation and sentiment reports, from about 30 percent earlier Friday.

Nevertheless, the two-year note, which is particularly sensitive to expectations for Federal Reserve rate moves, may still end up with the worst week in 26 years. The note's yield, which moves inversely to its price, has jumped more than 60 basis points in just one week.

"Yields have gone to pretty attractive levels and the Fed is on the case if there is any inflation: they are talking tough. The market has discounted three rate hikes by the October meeting. I think that's enough for now," Rupkey said.

Over the past week, global central bankers have expressed heightened concerns about headline inflation pressures driven by surging global food and energy prices.

The benchmark 10-year Treasury note's price, which moves inversely to its yield, traded up 7/32 for a yield of 4.19 percent, versus 4.22 percent late Thursday.

Data showed on Friday that U.S. consumers' long-term inflation expectations, a key focus of recent inflation concerns the Federal Reserve has acknowledged, held steady in June from May's peak, which was the highest in 13 years.

The Reuters/University of Michigan preliminary June index of confidence reading was 56.7, below economists' median forecast for 59.5. Respondents' one-year inflation expectations declined to 5.1 percent from May's 5.2 percent.

Bonds traded in highly volatile fashion. Some investors were tempted back into the market with yields now at more enticing levels after the past week's sharp sell-off, analysts said.

Another reason for the tug-of-war on Friday which sent bonds careening several times between positive and negative territory, was the market's conflicted view about future inflation trends, analysts said.

"In the bond market there are two trains of thought right now. One is that because inflation is a lagging indicator and because the economy is slowing, that it will trail down," said William Larkin, portfolio manager with Cabot Money Management in Salem, Mass.

"Then there's the other side that looks at the global story of energy that says: 'Oh, this is a clear sign: this is textbook stuff: we can't get away from rising energy prices'," Larkin said. "I tend to look at that side," he added.

Larkin expects the 10-year Treasury note's yield to rise to between 4.65 percent and 5.5 percent over the next six- to eight months as inflation pressures continue to rise.

The highly inflation-sensitive 30-year bond's price edged up 3/32 for a yield of 4.75 percent, versus 4.76 percent late on Thursday.