Bonds Shake Off Early Weakness

Wires out of Yugoslavia trigger a short-covering rally, repairing options-related damage.
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The Treasury market overcame early weakness related to Friday's options-expiration. In what participants attributed to short-covering and the possibility of a resolution to the Kosovo crisis, bonds and notes took off at about 2 p.m. EDT, and most issues ended the day 2 basis points lower in yield.

The benchmark 30-year bond finished 9/32 higher at 95 8/32, dropping its yield 2 basis points to 5.58%. There were no economic releases today, and while there was plenty of headline risk with the

Group of Seven

nations meeting in Washington and

New York Fed


William McDonough

speaking during market hours, the events didn't generate any market movers.

Treasury issues remain mired in the range they've inhabited since late February, which for the long bond is defined by a low yield of around 5.45% and a high yield of around 5.70%. "We're waiting for some resolution of the high-growth, low-inflation story," said Ken Logan, managing analyst at

Thomson Global Markets

. "Till then we're stuck in this range," with economic data, new bond issues by corporations or the Treasury, and other news events determining the market's direction from day to day.

The market tanked in the morning because of a development related to Friday's expiration of options on bond futures at the

Chicago Board of Trade

, said Rick Santelli, vice president at

Sanwa Futures

in Chicago. Basically, Santelli said, market makers who had sold put options on the June Treasury contract were surprised over the weekend to learn that many of the holders of the options wanted to exercise.

The 121 puts were the chief culprit, Santelli said. The contract settled Friday at 120 31/32, leading put sellers to assume that most holders would allow their only slightly in-the-money options to expire worthless. Instead, Santelli said, holders were "assigning" to sellers roughly 60% of the expiring options, meaning they wanted their expiring options replaced with new ones at the same strike price.

As a result, market makers who before expiration had been long the market (sellers of puts are effectively long, since they are obligated to buy if the option is exercised), and who expected to end up with no position when the options expired, "ended up long at 121 a lot more than they expected to, based on the way the market traded on Friday," Santelli said.

To hedge their risk, they sold.

Their selling kept the prices down for much of the day. Then, at around 2 p.m, the

Associated Press

reported that the deputy prime minister of Yugoslavia,

Vuk Draskovic

, had said his government was ready to accept a peace deal under which


countries could send troops to Kosovo as part of a


peacekeeping force.

It wasn't clear if

Yugoslav President Slobodan Milosevic

was on board with that statement. Till now he has rejected the idea of foreign troops in Yugoslavia. But the bond market doesn't always wait for confirmation. The report spurred buying because in recent sessions, fear has spread that the escalating cost of the ongoing campaign could gobble up the federal budget surplus, leading the Treasury to issue more bonds and notes than had been expected.

"History shows us that war has been negative for bonds," Logan said.

Short-covering was also responsible for the turnaround, triggered at the 120 24/32 level on the June contract, Logan and Santelli said.