Mixed Economic Data Help Treasuries Fight Back to Even

A stonger-than-expected report on the industrial sector knocked the Treasury market lower this morning, but later in the day, surprisingly weak readings from two relatively minor economic reports helped the market recoup its losses.

After trading down as much as 11/32 in early action, the benchmark 10-year Treasury note ended up 1/32 at 103 9/32, trimming its yield half a basis point to 6.045%. The 10-year note outperformed both shorter-maturity issues and the 30-year bond. The bond ended down 8/32 at 104 16/32, lifting its yield 1.8 basis points to 5.927%.

At the Chicago Board of Trade, the September Treasury futures contract lost 5/32 to 97 4/32.

The initial damage to Treasuries came from the industrial production report for May. Industrial production rose 0.4%. Not a large gain by historical standards, but economists polled by Reuters had forecast a drop of 0.3%, on average.

Meanwhile, the capacity utilization rate, part of the same report, held steady at 82.1%. It had been expected to decline to 81.6%.

The results flew in the face of earlier data indicating that economic growth is slowing -- specifically, the May employment report, which detected a loss of 116,000 private sector jobs, the first decline since January 1996 and the largest since November 1991.

Bond investors are anxious to see economic growth slow, because they fear that the above-trend growth of the last several years threatens to ignite inflation.

The industrial production report "raises question marks about the accuracy of the May payroll report," Miller Tabak bond strategist Tony Crescenzi wrote on his Web site, Bondtalk.com. "Because production and employment growth tend to go hand-in-hand, one report or the other is flashing a misleading signal. Although the answer is probably somewhere in-between, the production report suggests at the very least that payroll growth was not nearly as weak as the last report suggested."

Ken Mayland, president of ClearView Economics, agreed that the IP report probably takes the more accurate measure of the economy. "Which figures are right? I would put my money on the IP data," Mayland wrote. "And this suggests to me that measured employment could come roaring back when the jobs data for June are released."

Later in the session, however, the Treasury market got some minor indications that perhaps the IP report had overstated the case.

The Philadelphia Fed Index fell much more than expected in June, to 1.7, the lowest reading since November 1998, from 20.2 in May.

And the Housing Market Index fell to 58 in June, the lowest since November 1997, from a revised 62 in May.

It was a fifth session in a row that the bond underperformed shorter-maturity Treasuries. This relates very specifically to the shift in expectations about the Fed over that period, market analysts say. The majority has gone from believing that another rate was likely at the Federal Open Market Committee's next meeting on June 27-28, to believing that a June hike is unlikely. "With the Fed on hold, there's less reason to be short twos" -- two-year notes, which are much more sensitive to changes in the fed funds rate , said Kevin Logan, senior market economist at Dresdner Kleinwort Benson.

At the same time, after having run up in price very sharply over the last six months because of government initiatives to reduce the supply of the issue, the 30-year bond has begun to surrender some of its liquidity premium, said Mike Franzese, a trader at Zions First National Bank. In other words, with 30-year bonds falling into such short supply that trading them becomes a difficult exercise, the premium the bonds command for their scarcity is being partially offset by a discount for illiquidity. "People aren't going to trade it; it's going to be toxic waste," Franzese said.

Market rumors which surfaced last week that the Treasury Department will stop issuing the 30-year bond this year or next year are responsible for the emergence of the illiquidity discount, Franzese said.

Economic Indicators

In other economic news, initial jobless claims fell in the latest week to 296,000 from a revised 312,000, the highest level of the year.

Currency and Commodities

The dollar fell against the yen and gained against the euro. It lately was worth 106.54 yen, down from 106.62. The euro was worth $0.9541, down from $0.9577. For more on currencies, please take a look at TSC's Currencies column.

Crude oil for July delivery at the New York Mercantile Exchange rose to $32.95 a barrel from $32.78.

The Bridge Commodity Research Bureau Index fell to 224.42 from 224.71.

Gold for August delivery at the Comex fell to $292.10 an ounce from $294.20.

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