Bond Prices Hold Gains as Inflation Worries Ease

U.S. Treasury debt prices rallied Tuesday as press reports discussing the outlook for Federal Reserve policy encouraged markets to tone down their expectations for near-term interest-rate hikes.

Data showing a drop in U.S. housing startsand a higher-than-expected increase in wholesale inflation in May had scant impact on a market preoccupied with the news reports, which made market participants consider whether expectations of aggressive rate hikes this year have been overdone.

"A lot of articles in the past couple of days" seem to be saying "that the market has placed too much (emphasis) on Fed rate hikes in months to come," said Sean Murphy, Treasury trader at RBC Capital markets in New York.

Two-year yields, which are especially sensitive to shifting perceptions on the near-term outlook for Fed monetary policy, suffered their biggest one-day drop in three months as investors "curbed their enthusiasm" for as many as three Fed interest-rate hikes by the end of the year.

Last week, yields on two-year notes posted their sharpest weekly rise in 26 years as anti-inflation talk from the Fed and other central banks persuaded the market that the Fed could raise interest rates two or three times before the end of the year.

Gary Thayer, senior economist at Wachovia Securities in St. Louis, Mo., said Tuesday's reports showing a 3.3 percent drop in housing starts in May and another showing a 1.4 percent rise in wholesale inflation demonstrated that the Fed has to monitor both the downside risks to the economy and the inflation outlook carefully.

The twin considerations mean that the Fed "will hold rates steady for the time being," he said.

An unexpected 0.2 percent decline in U.S. industrial production in May, pointing to weak economic activity, reinforced that view while industrial capacity use declined, foreshadowing a possible easing of inflation pressures.

In morning trade, benchmark 10-year Treasury notes were up 15/32 in price, their yields easing to 4.22 percent from 4.27 percent Monday.

Two-year Treasury notes jumped 6/32, their yields easing to 2.95 percent from 3.04 percent Monday.