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Bond Brief: Refunding Woe

Ignoring soft ISM data, prices take a hit after the Treasury says it will offer $48 billion in debt next week.

Updated from 11:56 a.m. EST

Treasuries fell Wednesday and the yield curve inverted again Wednesday as the Treasury's announcement that it will soon sell $48 billion in debt for its quarterly refunding weighed on prices.

The benchmark 10-year note ended the day down 11/32 of a point to yield 4.56%. The 30-year bond dropped 16/32 of a point to yield 4.71%. Prices and yields move in opposite directions.

In shorter-dated debt, the five-year note fell 8/32 to yield 4.51%, while the two-year lost 4/32 to yield 4.58%, higher than the 10-year yield. 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, a perception that has historically preceded an economic slowdown or recession.

An inversion in the spread between 10-year and three-month yields is the spread that the

Federal Reserve

is most concerned with, according to Miller Tabak. The brokerage firm says that once the inversion between these yields hits the midteens, in terms of basis points, odds of a recession within four quarters jumps to 30%. (The three-month bill ended the day yielding 4.47%.)

All economic reports issued in the next few weeks will fall under intense market scrutiny now that the Fed has made clear that its next rate move will be dependent entirely on the strength or weakness of economic data, as

reported here.

But Matthew Smith, vice president at Smith Affiliated Capital says that the recent Fed rate hike, not monthly employment report, should the market's focus.

"Yesterday's rate hike, and the lagging effects of the past 13 increases... that's going to put a crimp on the economy going forward," he says. "Inflation is at pre-Katrina levels and last quarter's GDP was only at 1.1% and the Fed had been looking for a number above 3%."

Other economists believe that the economy is still growing strong, and say that upcoming employment data will support this view.

"The economy loses 2.2 million jobs between December and January, the biggest seasonal adjustment of the year... but when you remove all the holiday excess I think we'll see job growth will be very healthy," says Madeline Schnapp, director of macroeconomic research at TrimTabs.

Schnapp's firm has found that, based on daily tax withholdings, more people are working and that workers are making more money. That contradicts Tuesday's employment cost index data which showed inflation-adjusted wages fell 0.3% in 2005

Weekly jobless claim information is due out Thursday, which traders will closely watch to get a sense of how Friday's January payrolls report will look.

Wall Street expects payrolls to rise to 250,000 from December's weak 108,000, with unemployment at 4.9%.

Fed officials have hinted in speeches past 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.

The market has until March 28 to adjust before the next

Federal Open Market Committee

meeting and possible rate hike. It may get a clearer picture of where interest rates are heading on Feb. 15, when Ben Bernanke testifies before Congress in his first public outing as Fed chairman.

Wednesday's initial selloff had less to do with economic data and "was consistent with usual auction cycle patterns," says Bulent Baygun, head of U.S. fixed-income strategy at Barclays Capital.

Baygun was referring to the morning refunding announcement that 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.

The announcement was slightly larger than projections by RBS Greenwich Capital for $18 billion in three-year notes, $13 billion in 10-years and $15 billion in 30-year bonds. Both Barclays Capital and RBS are among the 22 primary U.S. government securities dealers that are required to participate in Treasury auctions.

"The supply increase was expected, and the numbers didn't miss margins broadly in any direction," says Baygun. "When you get closer to new supply, it tends to bring prices down as people

make room for the new debt."

There have been early indications that demand for the new issues will be strong, according to Steve Rodosky, senior vice president of Pacific Investment Management, the world's largest bond broker.

"We can expect the market to take supply in stride," he says. "And the fact that the 30-year bond issue was about $1 billion less than most people thought it would be helped richen the price for the new issue."

In Wednesday's economic news, the Institute for Supply Management's index came in at 54.8 for the month of January vs. expectations for it to hold steady near 55.5. A reading over 50 indicates expansion.

Both new orders and production fell to their lowest levels since August, while the employment index of the ISM report fell to 51.3. Export orders topped import orders for a third month, and prices paid edged higher to 65.

The report covers only the manufacturing sector, but it often sets the tone for the month as one of the first comprehensive reports in the period. The soft employment reading was closely scrutinized in light of Friday's January payrolls report, which is expected to show a climb to 250,000 and unemployment holding below 5%.

Separately, December construction spending came in strong, with a 1% gain overall vs. estimates for a slight 0.2% rise. The Commerce Department also said that the November number was upwardly revised to 0.5% from 0.2%.

The Mortgage Bankers Association's mortgage applications index fell 5.1% over the last week, with purchases seeing the largest drop since mid-June.

Some economists fear that a housing sector slowdown will pinch consumers, slow spending and eventually act as a drag on the economy.

And oil prices ended the day down $1.36 at $66.56, after the Energy Information Administration reported that crude inventories rose by 1.9 million barrels vs. estimates for a 1 million barrel gain. (Read's

full coverage


The bond market has also been keeping a wary eye on crude prices, worried that higher energy costs could seep into core inflation.