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Bonds Sigh With Relief, Rally Off PPI

The market is conceding 25 basis points from the Fed, but it's stopped worrying about more -- for now.

A better-than-expected

Producer Price Index

report has bonds rallying this morning, although the upturn is being met with dealers selling some of the Treasuries they're holding after the three-day quarterly refunding, which ended yesterday.

Lately, the 30-year Treasury bond was up 31/32 to trade at 100 3/32 to yield 6.12%.

The PPI rose 0.2% in July, below the


consensus estimate of 0.3%. The core PPI, which excludes volatile food and energy prices, was unchanged; that's also a friendly figure for the market, which was looking for a 0.1% increase.

Today's PPI report doesn't change the market's view that the

Federal Reserve

will probably hike the

fed funds target rate

to 5.25% Aug. 24. But it gives the market an impetus to retreat from the high yields of the year, reached yesterday in the wake of several inflationary reports and the quarterly refunding supply. With a 25-basis-point rate hike already priced into the market, some now believe that Treasuries have value at these levels. (It also quashes the 50-basis-point talk, which one trader attributed to "people who are looking to get out of a position, or panicking.")

Trading in the fed funds futures

contract illustrates how today's report has affected the market's view of what the Fed's got planned. The September contract closed yesterday at 5.245%. This puts the odds of a Fed hike by the beginning of September at 98%. Today it's rallied to 5.23%, or a 92% chance. But the December contract settled yesterday at 5.395%, a 58% chance of another 25-basis-point hike by the beginning of that month. Lately it was yielding 5.37%, or a 48% chance.

Today's rally has given dealers an excuse to unload some of the paper they've bought during the Treasury's $37 billion quarterly refunding, which ended with yesterday's $10 billion 30-year bond auction. So far, the rally's held up, in part due to the positive activity in the futures market and a Fed coupon pass. The Fed bought $877 million in Treasuries maturing between April 2000 and January 2001 to add liquidity to the banking system.

Lately the September bond contract, traded at the

Chicago Board of Trade, was at 114 8/32, up 20/32. Traders have said today's key level is 114 9/32, which is where the September bond futures contract closed last Friday after the July

employment report

was released. If the contract can close above this level today, it would be a bullish signal for the market, according to traders.

"We're more than recovering the losses of late yesterday," said Dana Johnson, head of capital markets research at

Banc One Capital Markets

. "There's a sense of a relief trade developing here. The market's point of view is that the Fed tightening process is likely to be gradual and limited as long as core inflation doesn't accelerate."

The PPI's index of core goods in the intermediate stage of processing rose 0.4%, the fifth straight increase, while core goods in the crude stage rose 2.3%, the third straight increase. This is a potential worry down the road because if producers are spending more money on materials and unfinished goods, they could eventually have to pass those price increases on to the consumer.

"The pipeline

inflation pressures are beginning to develop, so the Fed should and will move, but given that the finished-goods figure is well-behaved, they don't need to move aggressively in any sort of rapid-fire way," Johnson said.

Also today, the

University of Michigan's

index of

consumer sentiment

fell to 104.6 in August from 106 in July.