Bond Yields Riding High Upon a Deep Depression

The taste of Friday's jobs report and the prospect of swallowing $37 billion in Treasury bonds made for a queasy day.
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The weekend is most definitely over. Traders came in this morning and resumed the selling, taking bond yields to their highest levels of the year. The fire was stoked today by two types of torch-bearers -- those looking ahead at this week's quarterly Treasury refunding, and those looking back in anger at

Friday's surprisingly strong

employment report

.

"There's a shift in sentiment toward higher yields," said a drained-sounding Bill Hornbarger, fixed-income strategist at

A.G. Edwards

. "We've got the refunding this week and I think people are very nervous about the

Fed

."

Treasuries slowly eroded throughout the day, and the 30-year bond was lately trading at 86 25/32, down 1 1/32, but off the low of 86 23/32. The yield rose 6 basis points to 6.24%, the highest closing yield since Nov. 4, 1997.

The push toward higher yields reflects the market's assumption that the

Federal Open Market Committee

will hike the fed funds target rate from its current 5% at its next meeting, Aug. 24. But today's selloff is also typical of traders and investors preparing for the Treasury market's three-day quarterly refunding, which begins tomorrow with the sale of $15 billion in five-year notes. The five-year note fell 11/32, its yield hitting 6% for the first time since Oct. 22, 1997.

Typically, the market sells Treasury securities in anticipation of the auction in order to get the lowest possible price (and the highest yield). The five-year auction was sold with a coupon of 5.25%, so investors are going to get significantly more value than that note, which has been a consistent loser since May. Because the market tends to try to push yields up as much as possible, "you'd expect a bounce-back to follow," said

ABN Amro

market strategist Charles Reinhard.

Reinhard believes the market will bounce back after the refunding is completed because he thinks today's cheapening up of the notes indicates that "this is a good setup." During the third quarter the Treasury is

paying down $11 billion in debt, so the inflow of that cash could result in some buying during the next couple months.

Reinhard added that today's preparation comes "on the heels of some bearish reports, which makes it easier to extend the move."

Most specifically, Friday's July employment report and Thursday's

productivity and unit labor costs

figures. Nonfarm payrolls rose by 310,000, beating expectations by more than 100,000, and average hourly earnings rose 0.5%, compared with

Reuters'

consensus estimates for a 0.3% increase. And productivity only grew 1.3% in the second quarter, while labor costs rose by 3.6%.

Market watchers believe these inflationary reports give the Fed impetus to raise interest rates come month-end. Indeed, the September fed funds contract, traded on the

Chicago Board of Trade, is trading at 5.25%, putting at 100% the odds that the Fed will raise the funds target Aug. 24.

The bond market's ability to sustain a potential post-auction rally will be determined by economic data and speeches by Fed officials. Believing the August rate hike already accounted for, the market's new obsession is determining whether the Fed will raise rates at the succeeding FOMC meeting, Oct. 5.

The Treasury will sell $12 billion in 10-year notes Wednesday and $10 billion in 30-year bonds Thursday.