Goldilocks Bloodies Bonds

As the days wear on before Christmas, the market will be more thinly traded, and investors are squaring up their bets with this week's data, says Michael Cloherty, head of interest rate strategy at Banc of America Securities. Wednesday's selloff puts the bond market back into a higher-rate range that could stay in place through the end of the year, he adds. The range would mean no sliding below 4.5% on the 10-year, for example.

As for the Fed's cycle, "the bond market took out a little less than half of an ease by the end of 2007 on Wednesday," Cloherty says.

The fed funds futures market more aggressively removed rate cuts from the near future, as traders bet Wednesday that the first cut won't come until June, according to Miller Tabak. The futures market now puts 4% odds of a cut at the January meeting, down from 30% on Dec. 1. The market puts 18% odds on a cut in March, down from 70% at the start of the month, and the market has reduced odds of a cut in May to 44% from 100% just last Thursday.

The bond market's bad day was punctuated by another large jump in mortgage applications, by 11.4% in the Mortgage Bankers Association's latest weekly tally. Even with the Fed's characterization Tuesday of the housing downturn as "substantial," evidence is mounting that the worst may be over.