Bond Brief: Afternoon Delight

Long-dated Treasuries rebound sharply, overcoming fear of the Fed and concern about the upcoming auction.
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Updated from 10:59 a.m. EST

Long-dated Treasuries rebounded sharply Friday afternoon while the yield curve inverted further as traders grappled with the possibility of more Fed rate hikes and debated the outlook of next week's massive Treasury auctions.

Evidence that labor markets and factory utilization rates are tightening, numbers that could point to inflationary pressures in the economy, weighed on Treasury prices in the morning.

Phil Roth, chief technical market analyst at Miller Tabak, now sees a 90% chance that the fed funds rate will hit 4.75% in March, and he sees a 60% chance that they will go to 5.0% by June.

But next week's auction, particularly the fate of the 30-year bond, held final sway over the market, sending yields on the long bond down by 11 basis points and the yield on the 10-year down about 9 basis points. Prices and yields move in opposite directions.

The benchmark 10-year closed up 8/32 of a point to yield 4.53% after hitting a session high of 4.61% Friday morning. The 30-year bond soared a full point to yield 4.63%.

The five-year note edged higher 2/32 of a point to yield 4.48%, while the two-year note was up one tick to yield 4.57%, 4 basis points more than the 10-year yield and the most inverted that part of the yield curve has been since late 2000, according to Briefing.com.

Longer-dated maturities usually yield more to compensate investors for taking on the additional risk of a longer-term loan. When yields on the short end rise higher, "inverting" the curve, it could mean that investors see more risk in the near term.

Yield-curve inversion has historically preceded an economic slowdown or recession, particularly an inversion of the spread between 10-year and three-month Treasuries. The three-month Treasury yielded 4.46% at the end of the session, well below the 10-year yield.

The Treasury will sell $21 billion in three-year notes, $13 billion worth of 10-year notes and $14 billion in 30-year bonds next week, news that has weighed on the market as traders shuffle their portfolios in anticipation of additional supply.

A huge amount of corporate debt has already hit the market, along with Treasuries, with corporate issuance soaring to $97 billion in January from about $55 billion in December, nearly double the amount posted in January 2005.

In the corporate debt market,

HCA

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said Friday that it had sold $1 billion in 10-year notes.

Of particular interest to the market is a debate over how popular the 30-year issue will be, particularly with foreign central banks. Feb. 9 will mark the first 30-year auction since 2001, so there is a large amount of speculation over how much demand there is for the bond.

Foreign central banks have been buying longer-dated debt and keeping yields low. The Fed just reported that foreign holdings of Treasury and agency debt rose by $3.168 billion in the past week.

But Treasuries accounted for a decline of $2.686 billion while agency debt jumped by $5.854 billion, so foreign participation next week will be closely watched.

"Foreign buyers typically don't take get into 30-year auctions as much," says Richard Gilhooly, interest rate strategist at BNP Paribas. The firm is one of 22 primary dealers that must participate in Treasury auctions.

However, pension funds, insurance companies and money managers that need longer-dated maturities in their portfolios may well be eager for the opportunity to buy the 30-year, he says.

But the 30-year's afternoon rally implies that the market is sticking with the old paper, rather than waiting to pick up the new issue.

The midday reversal caught many by surprise after a morning full of data that were mixed but had some evidence that could be considered very bearish for bonds.

Amid the slew of economic reports released Friday morning, the January payrolls number was the most closely watched. The number came in at 193,000, the Labor Department said, well below Wall Street estimates for 250,000.

But the December figure was upwardly revised to 140,000 from 108,000; and the unemployment rate fell to 4.7% from 4.9%. Wall Street had expected the unemployment rate to hold steady.

Federal Reserve

policy makers have spent months saying that they are carefully monitoring the employment picture because the U.S. is close to "full employment," or the lowest level of unemployment possible before wage inflation sets in. Bond traders loathe inflation because it erodes the value of fixed-income investments.

"It missed the headline expectation, but this is actually a fairly strong report," says Michael Darda, chief economist at MKM Partners. "We had upward revision for the last two months that have taken us to where we were before the hurricanes interrupted the labor market recovery ... this is a sign of resilience and strength."

Moreover, hourly earnings rose by 0.4%, vs. forecasts for a 0.3% rise, and the December number was upwardly revised to 0.4%, from 0.3%.

Darda says that much of this gain was made in low-end wages, which he says are accelerating at their fastest pace since 2001.

The market had been bracing itself for a strong monthly payroll report after Thursday's initial jobless claims number unexpectedly fell by 11,000 to 273,000, vs. expectations for claims to rise to 295,000. The Labor Department release also said that the four-week moving average for jobless claims hit 284,000, the lowest level since June 2000.

Central bankers have issued similar warnings about rising capacity utilization rates. Economists generally worry that if more than 85% of industrial capacity is in use, bottlenecks could form and create inflationary pressure.

December factory orders also rose by 1.1%, vs. expectations for a 1.0% gain. And the November number was revised to 3.3% from 2.5%.

Shipments rose a strong 2.2% while inventories ticked higher by 0.5%, leaving the inventories to sales ratio at 1.15, a new record low.

But a disappointing Institute for Supply Management non-manufacturing report kept a floor under Treasury prices. The index fell to 56.8 from 61, vs. expectations for a smaller drop to 60. And the University of Michigan Consumer Sentiment index was downwardly revised by 2.2 points to 91.2.