Bonds Bounce Back After Killer Trade Report

The wider-than-ever trade deficit smacked the dollar, stirring fear of higher inflation down the road.
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Treasuries are little changed this morning, after trading sharply lower on concern that a weakening dollar will lead to higher inflation down the road. It's a relatively slow day in the market, with traders biding time until next Tuesday's

Fed

meeting.

Following the release this morning of the June

international trade

report, which hit the dollar with the news that the trade deficit has ballooned to yet another new high, the benchmark 30-year Treasury bond traded down as much as 15/32. But helped by a coupon pass, in which the Fed buys securities on the open market in order to inject enough liquidity into the banking system to keep the fed funds rate on target, it was lately down 1/32 at 101 21/32, lifting its yield 1 basis point to 6.01%.

The news that the trade deficit had widened to $26.4 billion in June from $21.2 billion in May shocked many economists. The average forecast, according to

Reuters

, was for a narrowing of the deficit to $20.5 billion.

The wider deficit will almost certainly cause a downward revision to second-quarter

GDP

, which the government's initial estimate says advanced 2.3%. But it isn't bullish for bonds because the reason for the widening deficit is surging demand in the U.S. for imports. (The trade deficit grew in June because import growth outpaced export growth, 3.9% to 0.5%.) At the same time, U.S. producers are coping admirably with the foreign competition,

Moody's Investors Service

chief economist John Lonski explained.

"The jump in imports might be overstating the harm a wider trade deficit is inflicting on the U.S.," he said. "Some companies have been hurt by import competition, but the rebound in corporate profitability shows that the U.S. economy is not in desperate straits because of foreign competition."

A widening trade deficit may buy the Fed some time as it considers whether and how much to hike interest rates, Lonski said, but fundamentally a wider deficit is "further evidence of a very rapid pace of domestic spending that will pose more of an inflation threat as economic recoveries proceed through the rest of the world."

The dollar is the agent of that threat. The trade deficit pressures the dollar by sending it overseas, where it will be exchanged (sold) for other currencies. As the dollar weakens, imports become more expensive in the U.S.

The dollar fell sharply after the 8:30 a.m. EDT release of the trade report, but has since rebounded. It was lately worth 111.11 yen, down from 111.92 yesterday.

Marcello Frustaci, senior vice president and trader at

Daiwa Securities

, said Treasuries will probably have trouble improving much more than they have in the last week until the Fed has had its say on Tuesday. The focus, he said, is on the statement the Fed will presumably release when the meeting concludes.

Almost everyone expects Fed officials to hike the fed funds rate to 5.25% from 5% at the meeting, but what will they say about why they did it, and what might they say about the prospect for additional hikes? "If they say they're raising the rate to bring it into alignment with the market, I would regard that as very, very bullish," Frustaci said. "But if they say it's because of an overheating economy and inflation pressures, that's more serious."