Bonds Pare Losses on Weaker-Than-Expected Manufacturing Report

But with the quarterly refunding approaching, the bond outperformed shorter-dated paper.
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The bond market lost some additional ground today, but the losses were relatively narrow thanks to a less-robust-than-forecast report on the state of the manufacturing sector.

After trading down as much as 18/32 in the half hour before the 10 a.m. EDT release of the April

Purchasing Managers Index

, the benchmark 30-year Treasury bond finished the day down just 1/32 at 94 2/32, its yield unchanged at 5.66%.

The long bond outperformed the rest of the Treasury curve, however, thanks to the supply outlook for Treasuries. Next week, the Treasury will auction new five- and 10-year notes in its quarterly refunding. The May refunding is the only one of the four that does not also include a 30-year bond auction. Because the long bond will be in relatively short supply compared to shorter-dated securities, it was able to hold more of its value today. The 10-year note, for example, lost 5/32, lifting its yield 3 basis points to 5.38%.

The market headed lower early in the session, trading-desk sources said, chiefly out of fear that the April PMI would mimic the behavior of two previously released regional manufacturing reports and deliver a strong upside surprise, signifying that the factory sector has fully shaken off the slowing effects of the Asian financial crisis.

The two regional manufacturing indices released ahead of the PMI, the

Philadelphia Fed Index

and the

Chicago Purchasing Managers Index

, both rebounded strongly in April. The Philly Fed Index, released

April 15, hit its highest mark (26.4, where 0 is breakeven) since July 1996, while the Chicago PMI, released

Friday, rose to the highest level (63.3, where 50 is breakeven) since February 1995. Expectations were for far smaller numbers.

Because of the massive damage that the Chicago PMI (and its sub-index measuring prices paid by Chicago-area manufacturers, which rose from 52.5 to 56.7) helped do to the bond market on Friday, traders were playing it safe ahead of this morning's release. "It was just nerves," said one, the head trader at a primary dealership. "People were saying, 'I don't want to be long into the number.'" Friday's losses, also triggered by a much-stronger-than-expected initial estimate of first-quarter

gross domestic product

, jacked up the long bond's yield to the highest level since April 1, and hiked note yields to levels not seen since early March.

They need not have worried -- the national PMI slipped to 52.8 from 54.3 in March (50 is breakeven). The average forecast of economists surveyed by

Reuters

was 55.0. And while a sub-index measuring prices rose from 43.2 to 49.9, it remained below breakeven for the sixteenth consecutive month, signifying that more manufacturers reported paying the same or lower prices in April than in March, than reported paying higher prices.

"The market was clearly headed lower" before the release, which "stymied the sell and forced some short-term shorts to cover," said another trader,

Prudential Securities'

co-head of government bond trading Scott Graham.

In the coming weeks, however, Graham expects to see still higher bond yields. "A lot of people have decided that the economy is stronger than anticipated, and further strength is going to be sold into," he said. Treasuries benefited today, he added, from the fact that it's a holiday in Japan. Lately, Japanese accounts have been sellers of Treasuries as the dollar has strengthened against the yen, as it did again today.

Interestingly, though, market watchers still aren't worried that the

Fed

might raise official interest rates in the months ahead. Another sub-index of the PMI, the supplier deliveries index, which can warn of inflation ahead by spotting supply bottlenecks, remains subdued,

First Union

chief capital markets economist David Orr noted in a published comment. The last time the Fed embarked on a sustained tightening course, in 1994, that index, oft-cited by Fed Chairman

Alan Greenspan

, was steadily on the rise, helping to explain "his aggressiveness then vs. his more relaxed tone currently," Orr wrote.

In addition, the head trader noted, the Fed is widely believed to be in "whites of their eyes" mode as far as inflation is concerned, meaning that it will insist on seeing concrete evidence of inflation across a range of indicators including the

Consumer Price Index

on a sustained basis before raising rates. That's a freedom the Fed hasn't always had, and it's made possible by the inflation-curbing productivity enhancements of the last several years, the thinking goes.

If there's a risk, the trader said, it's that the Fed switches its official bias from neutral to favoring higher rates in the next couple of months, in order to avoid tampering with interest-rate policy during the last quarter of the year, with Y2K approaching. "If they're going to raise rates," or even switch to a tightening bias, he said, "they've got to do it in the next couple of months." And the reaction will be equally negative to a rate hike or a bias shift, he predicted.