Auctions Over, Treasuries Rocket on Benign PPI

Oversold conditions yesterday magnified the response to today's mild inflation data.
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Bonds rallied sharply to end the week at their lowest yields since last Thursday. A milder-than-expected inflation report triggered the rally and a newly favorable supply picture magnified it.

The benchmark 30-year Treasury ended the day up 1 7/32 at 100 11/32, trimming its yield 12 basis points to 6.10%, its best close since Aug. 5. The long bond outperformed shorter-maturity notes, mainly because of supply considerations. The yield on the two-year Treasury note, for example, shed only 7 basis points to 5.70%.

The rally was unleashed by a weaker-than-expected July

Producer Price Index

, the key measure of inflation at the wholesale level. The PPI rose 0.2% overall, vs. an average forecast among economists surveyed by

Reuters

of 0.3%. The core PPI, which excludes volatile food and energy prices, was unchanged, vs. expectations for a 0.1% gain.

At the earlier stages of production (the headline PPI measures finished-goods prices), inflation wasn't quite so subdued. The PPI for core crude goods, for example, rose a whopping 2.3%. Economists say correlations are generally low between core and finished-goods prices. Still,

Daiwa Securities

chief economist Mike Moran wrote in a research note that "the change serves as a reminder that inflation risks are on the upside."

The report doesn't challenge the widespread view that the

Fed

is very likely to hike its target for the fed funds rate, the key short-term interest rate, to 5.25% from 5% when it meets a week from Tuesday. But the PPI data certainly make it harder to argue that more than one rate hike will be necessary to bring economic growth rates down to levels Fed Chairman

Alan Greenspan

and his gang are comfortable with.

But that's not why Treasuries rallied so sharply. ("The PPI was good, but it wasn't

this

good,"

Donaldson Lufkin & Jenrette

Treasury market strategist David Ging said.) Market participants attributed the gains to the fact that bonds sold off so hard yesterday, largely because of the Treasury's auction of new 30-year bonds.

The bond auction concluded the Treasury's quarterly refunding, or sale of long-dated notes and bonds. The refunding often marks a rough patch for the market, even in happy times. (These are unhappy times in the bond market, except for those who have been short for the last 10 months.) And it marked a particularly rough patch yesterday. The 30-year issue was awarded at a higher-than-expected yield, indicating half-hearted bidding for it by dealers. Stuck with bonds they didn't want, the dealers had to scramble to clear their shelves so as not to be too exposed to the risk of a stronger-than-expected PPI.

"Part of the reason we were down yesterday was because the bond auction was poorly distributed," said Dave Connors, managing director at

Credit Suisse First Boston

. "It ended up in dealers' hands, and they were moving out of positions ahead of the PPI. It was artificially low."

The bond outperformed short Treasuries today because it was the bond that suffered disproportionately yesterday as it went begging for buyers.

Also supporting Treasuries today was the general notion that with the refunding finished, the market doesn't have to contend with fresh supply again until November, when the quarterly refunding won't even include a new 30-year bond.

The next challenge facing the market is the release of the July

Consumer Price Index

, a much broader inflation measure, on Tuesday. It's expected to rise 0.3% overall and 0.2% at its core, and ahead of it Ging sees "not much upside" for Treasuries, with a probability of some profit-taking on Monday.

Connors said a stronger-than-expected CPI could certainly return Treasuries to their high yield levels for the year, reached earlier this week. But whether the Fed raises interest rates more than once depends more on the August data, Connors said. He thinks that higher mortgage mortgage rates and higher corporate bond yields will slow economic growth sufficiently that only one rate hike will be necessary. "What will drive the decision to go an additional 25

basis points is nothing in this data cycle, but if we don't see the slowdown that we think is coming in the next couple of months," he said.