Bonds Squeeze Out One More Rally Before the Weekend

However, trading was thin ahead of next week's FOMC meeting.
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The bond market has already switched from meaningful trading to

Fed

-related nail chewing. With the exception of the 30-year bond, which got a bit of a liquidity boost today, the rest of the yield curve isn't too far from where it left off yesterday evening.

Being a summer Friday, just a couple days before the Fed's Tuesday meeting, the expectation was for quiet. The market didn't disappoint -- with trading desks understaffed and those in the office reluctant to take a big position before a potential change in interest rates, volume was way down. Tracker

GovPX

said just $23.3 billion of securities changed hands, or 36% less than the average Friday in the past month.

Lately the 30-year Treasury bond was up 21/32 to 101 30/32. The yield fell 5 basis points to 5.98%, its lowest closing yield since July 22.

The 30-year bond has been the best performer since the July

Producer Price Index

was released last Friday. This bond trades on inflation expectations, so it turned positive because of the friendly PPI, and continued that run with the benign July

Consumer Price Index

, released Tuesday. It's also the market's belief that the Fed will raise the fed funds rate to 5.25% from 5% Tuesday in order to fight inflation.

Not that the rest of the market hasn't done well also. The two-year note yields 5.62% today -- last Friday it closed at 5.70%, and the 10-year has rallied to a yield of 5.87% from 5.98%. The tone changed with the release of the PPI, which was unchanged in July. Economic reports prior to this figure pointed to continued strength in consumer spending, a slight rise in wage pressures, and continued recovery in manufacturing. And though not many were taking it seriously, it had the market buzzing about a potential 50-basis-point rate hike come Tuesday. The PPI and CPI put the market back on firm ground.

"It looks like the market is on favorable footing," said Kim Rupert, senior economist at

Standard & Poor's MMS

. "We're still in a range, but we're trending toward the lower end of the range."

Whether the tone stays positive depends on what kind of statement the Fed releases with the presumed rate hike. In June, when the Fed hiked rates, it moved its directive back to neutral, which indicates no predilection toward moving rates one direction or not.

But the market was expecting a bias toward tightening rates, and that surprise, along with the dovish

statement the Fed released, spurred a prolonged rally from the markets. Since the Fed's been worried about asset prices and the overall effect it is believed that may have on increased consumer spending, they may not want to see this duplicated.

This time out, the market is prepared for a hike, and for the Fed to shift back into neutral, so the relief rally should be contained. However, forceful words from the Fed that highlight their concerns about wage pressures and inflation could put the market back into a funk.

"The market is not expecting further hikes after next Tuesday," said George Simon, Treasury market strategist at

A.G. Edwards

. (This hike is basically a done deal: The fed funds September

contract, an indication of where the market thinks rates are headed, is currently discounting a 88% chance of a hike, down from 92% earlier this week.) "If there is one

Tuesday, it'll be positive for the market, depending on what they say," he added. "And then the focus is still on economic numbers going forward."

The most important economic release next week is Thursday's

durable goods

data. But the market's been chiefly concerned with the price and wage measures, as well as the overall labor market. By default, that means the next red letter on the calendar is Friday, Sept. 3, when the August

employment report

is released.