Bonds Spell Relief F-O-M-C

A move wasn't expected but a change in bias was a remote possibility.
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Today's nonaction from the

Federal Reserve

gave bonds a reason for a relief rally, even though the market wasn't expecting a rate hike to begin with. After the 2:15 p.m. EST announcement, the entire curve appreciated, including two-year notes, previously under pressure due to curve-steepening trade

unwinding.

Lately the 30-year Treasury bond was up 25/32 to trade at 95 4/32, as the yield fell to 5.59%. The two-year note rose 3/32 to yield 4.96%.

To a man, the bond market was not expecting the Fed to raise interest rates today. But they weren't entirely dismissing the possibility that the Fed would change its bias to reflect growing concerns about economic strength. For the most part, economic data have been strong, despite recent individual reports such as February's 5% drop in

durable goods orders

.

Roseanne Briggen, market strategist at

MCM Moneywatch

, said the late rally in futures was also attributable to covering shorts.

Recent activity has involved traders placing a steepening trade, which involves selling short long bonds and buying two-year notes in a bet that the difference in yield between the two will widen out. A number of factors, including the flight-to-quality trade caused by the world's uncertainty over the conflict in Kosovo, helped make this trade a winner. In the morning, dealers were removing the trade by selling two-year notes and buying back bonds. The difference in basis points between the two widened to 63 basis points yesterday from 47 March 18, and lately was back at 63 basis points.

The Fed didn't even release a statement explaining the nonaction. Bonds continued to run in the afternoon, and two-year notes made up lost ground after the Fed announcement. Two-year notes aren't expected to extend this rally far, simply because the market overall still sees the next Fed move as a tightening. The July fed funds contract traded on the

CBOT is yielding 4.82%, still a 28% chance the Fed hikes rates by July.

Today's late long bond rally is also an acknowledgement of a few friendly factors just around the corner. Government bonds in recent years were at their worst in the first quarter, and performed strongly beginning in the second quarter through the rest of the year. This year the yield on the 30-year Treasury bond has risen about 50 basis points. Last year it fell 28 basis points in the second quarter after a flat first quarter.

"The long bond has gone up on average in the last several years during the first quarter and does well for the rest of the year," said Michael Shamosh, chief fixed income strategist at

Tucker Anthony

. "The first quarter is due to the traditional bonuses, Christmas sales and a couple of other things thrown in."

The

Treasury Department

will pay down a significant amount of Treasury securities in the second quarter as tax receipts pick up. Buying from the Japanese will pick up once their fiscal year ends tomorrow. In April 1998 the Japanese overall purchased $6.3 billion of Treasury securities, though in March they only sold $168 million, according to the Treasury.

Shamosh sees the market doing a bit better for these reasons, and also because the U.S. 10-year bond currently carries a much higher yield than other industrialized countries. Ten-year Gilts currently yield 4.52%; German Bunds are yielding 4.03%.

"It's a big spread over their own bonds, which means there's a greater incentive for foreigners to buy," said Shamosh. "Repatriation is over in Japan, so that cycle will start anew."

Sometimes when factors are lined up in this fashion, all the market needs is a push. Friday's

employment

report might be enough for a mild rally, influenced by weather though it may be. The current forecast for March nonfarm payrolls is 166,000, which would be the lowest figure since October.

"I think if we do

rally it'll be quickly reversed," said Jim Chassen, portfolio manager of the $80 million

Hibernia U.S. Government Income fund. "We'll see people test the upper and lower bounds of the range, but at the end of the day, we're at 5.5%."