Bonds Rise as Profits Are Taken on Curve Trade

The slight risk that the Fed will switch to a tightening bias makes it time to unwind.
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The long Treasury bond's price is up this morning as traders take profits on yield-curve-steepening trades ahead of today's

Federal Open Market Committee

meeting.

To profit from a steepening of the yield curve -- a widening of the difference in yields between long- and short-maturity instruments -- traders effectively sell short the long ones and buy the short ones. As long as the short ones outperform, causing the yield spread to widen, the trade is in the money.

Recently, it's been a very profitable trade. Chiefly because the Kosovo crisis fueled demand for the more liquid short end of the Treasury curve, the difference in yield between the two-year note and the long bond, a popular measure of the curve, spiked from 50 basis points last Monday to 63 yesterday.

The recent rise in oil prices (which as a potential precursor to higher inflation threatens to lift long-term yields disproportionately) and a seasonal tendency for long yields to rise as the Japanese fiscal year draws to its March 31 close (and Japanese accounts retreat as buyers) are also behind the recent steepening, said Charles Reinhard, market strategist at

ABN AMRO

.

It's time to take profits on the steepening trade because while Fed watchers broadly agree that the monetary policymaking committee is likely to leave interest rates and its (presumably neutral) bias unchanged, the risk in the meeting is that the committee will shift to a bias in favor of a higher fed funds rate, and that it will announce the change.

An announcement of a shift to a tightening bias would probably flatten the yield curve as short-maturity yields, which reflect market expectations for Fed policy, rose. So just in case, the steepeners are coming off. Traders are exiting the short end and buying back the long end.

"We had a pretty big steepening in the last week, and there are a lot of curve unwinds this morning," said Ken Logan, managing analyst at

Thomson Global Markets

in Boston. "The consensus

about the FOMC meeting is that there will be no change in policy and no change in bias. But if there is a risk it's that they do adopt a tightening bias. There is zero risk that they adopt an easing bias."

At the long end, the benchmark 30-year Treasury bond was lately up 8/32 at 94 19/21, dropping its yield a basis point to 5.63%. Meanwhile, the two-year note was down 1/32, lifting its yield 2 basis points to 5.03%. The spread between the two: lately 60 basis points.

The Fed will announce any change in interest rates, and possibly any change in the FOMC's official bias, at around 2:15 p.m. EST. If no changes are announced, Logan expects "a mild uptrade and re-steepening of the curve." On the other hand, if a tightening bias is announced, he expects a selloff in the short end that would squash the curve back to about 50 basis points.

Today's economic indicators aren't major market-movers. The

Consumer Confidence Index

edged up in March to 133.9 from a revised 133.1 in February. It peaked in June at 138.2. And the

APICS Business Outlook Index

, a manufacturing sector indicator, slipped in March for the second month in a row, to 49.3 from 50.8.