Bonds Embrace Dovish Fed

Bulls rejoice as the FOMC says the number of additional hikes 'probably would not be large.'
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Updated from 2:49 p.m. EST

The spread between the two- and 10-year yields widened Tuesday after the release of the minutes of the

Federal Open Market Committee's

Dec. 13 meeting, which raised hopes that the central bank would soon end its rate hike campaign and boosted the short end of the curve.

After seesawing in afternoon trading, the benchmark 10-year ended the session up 6/32 to 101-2/32, to yield 4.36%, down from 4.39% Friday. Just before the minutes were released, the 10-year had given back all of the morning's gains as the market braced itself for the possibility of unexpectedly hawkish comments.

Instead, the possibility that rate hikes may soon be over and attendant inflation speculation weighed on the 30-year, which lost 8/32 to yield 4.55%, up slightly from 4.54% in the previous session.

In shorter-dated debt, the two-year gained 4/32 to yield 4.33%, and the five-year added 8/32 to yield 4.30%. This steepened the two- and 10-year yield spread by about 3 basis points, after hovering near 1 for most of the day. Bond prices and yields move in opposite directions.

Last week, the 10-year yield fell below that of the two-year for the first time since 2000 on speculation that the Fed would continue to raise rates to stay tough on inflation.

While the FOMC minutes said that committee members anticipated more tightening ahead, it also said that members disagreed over how many hikes would be necessary and that "the number of additional firming steps required probably would not be large."

The news was also greeted positively by equity traders. The

Dow Jones Industrial Average

, which was modestly lower prior to the FOMC minutes, soared thereafter to close up 1.25% at 10,847.41. Following a similar path, the

S&P 500

closed up 1.6% to 1268.80, and the

Nasdaq Composite

jumped 1.7% to 2243.74.

"Wall Street is shifting to the view that the Fed is one

more hike and done ... and that 4.5% is definitely neutral" said John Herrmann, director of economic commentary at Cantor Fitzgerald, one of the world's top Treasury bond brokers.

The minutes also said that the Committee "would need to be mindful of the lags in the effect of policy firming on the economy," referring to the steady series of quarter-point rate hikes that have taken the fed funds rate from 1% in June 2004 to its current 4.25%.

"The other critical thing is that the 25-basis-point rate hike in January that's been priced in is being called into question," Herrmann said.

His three reasons for no hike in January are: that payroll growth in January and December may come in short of expectations; consumption growth in December was clearly not as strong as forecast (as evinced by

Wal-Mart's

(WMT) - Get Report

disappointing sales data); and that motor vehicle sales lagged heading into the holidays.

"These all reflect slowing manufacturing growth, and now I think there's a 25% chance the Fed doesn't hike in January," he added.

Fed fund futures were still pricing in 100% odds for a Jan. 31 rate hike, according to Miller Tabak, but odds of another hike by the March 28 meeting were recently at 56% vs. 62% prior to the Fed minutes.

Supporting the idea of a more dovish Fed were weaker-than-expected reports on manufacturing and construction Tuesday morning, which some traders interpreted as evidence that the Fed can ease off the brakes.

The Institute for Supply Management's manufacturing index for December fell 3.9 points to 54.2 -- a four month low -- vs. expectations for a dip to 57.5.

The report, which provides a forward view of actual orders and production, also showed that the prices paid index fell to 63 from 84 in October.

Separately, November construction spending rose just 0.2%, vs. expectations for a 0.7% rise. Residential spending came in flat, the weakest month since the segment declined in June, weighing on gains made in business and public spending.