The Treasury market weakened Monday, a selloff apparently sparked by a record-setting budget account deficit and weak foreign demand for U.S. assets. But rather than reacting to backward-looking economic news, the bond market is more likely just positioning itself ahead of Wednesday's Federal Reserve meeting.

The 10-year benchmark note was recently down 10/32, its yield jumping to 4.83%, from about 4.78% Friday. The 30-year was down 17/32, its yield rising to 4.95% from 4.91% Friday.

"This is more about trying to push yields up ahead of the FOMC meeting," says Bill Hornbarger chief fixed-income strategist at A.G. Edwards in St. Louis. The bond market is ever so slightly unnerved by the Fed's upcoming decision, as the phrase "close call" reverberates on trading floors. The August FOMC minutes revealed that members felt the decision to pause was not easy. That said, the bond market is still pricing in the soft-landing scenario, with no inflation and no more rate hikes.

In economic news Monday, the Commerce Department reported that the current account deficit grew to $218.4 billion in the second quarter of 2006, from $213.2 billion in the first quarter, and above economists' expectations for $213.5 billion. Weighing on the deficit were higher prices and an increase of imported energy, as well as more importing of automobiles. The U.S. deficit with China grew to $54.5 billion, from $49.3 billion in the first quarter. The second-quarter deficit amounted to 6.6% of U.S. GDP.

While the U.S. trade imbalance expanded, foreign investment in U.S. assets shrank. The Treasury International Capital system (TIC) data for July showed that net capital flows into U.S. assets fell to $32.9 billion in July from $75.1 billion in June. The flows are the weakest since 2005 and fall short of covering the $68 billion trade deficit for July.

While the current account deficit looks ugly on the surface, it was really "a last gasp" stemming from high oil prices during the second quarter, says T.J. Marta, senior fixed-income strategist at RBC Capital Markets. Marta believes the current account deficit is likely to "bottom out" here and moderate along with the slowing U.S. economy.

The TIC data revealed a virtual collapse in July among private foreign investors into U.S. assets. The only increase was foreign investment into U.S. equities. But TIC data, like the deficit, is very backward looking, and appetite for U.S. Treasury bonds clearly picked up again in August as yields fell across the board.

The August TIC data are likely to show a resurgence of interest, says Marta. According to a

Bloomberg

report, Japanese bond fund managers reported increasing their holdings of U.S. government bonds, betting that the summer rally will continue. Kokusai Asset Management Co., which houses the second-largest bond mutual fund, Daiwa Asset Management Co., and Fuji Investment Management Co. are increasing their bond holdings,

Bloomberg

reports.

The FOMC decision Wednesday is also weighing on Treasuries, as is a large corporate bond calendar. While odds are only about 20% that the Fed raises rates again at any point, the odds of a rate cut have fallen off the radar screen.

"There is a little profit-taking going on," says Marta, adding that U.S. Treasury Secretary Henry Paulson also reassured the international community that the U.S. economy is strong despite some weakness in the housing market. "The market should have more two-way risk," says Marta. And the market is revealing it too is a bit shaky about its recent bullish bet on Treasuries.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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