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Curve-Flattening Rally

Long-dated Treasury yields tumble on weaker-than-expected core PPI and retail sales data.

Updated from 1:10 p.m. EST

Treasury prices rose sharply Friday on the release of weaker-than-expected economic reports that traders hoped would help stop the

Federal Reserve's

tightening spree. The rally resulted in a renewed narrowing of the yield curve as long-dated Treasuries, which are more sensitive to economic prospects, fell more than shorter maturities, which tend to move in tandem with the fed funds rate.

The benchmark 10-year note closed up 14/32 of a point to yield 4.35% vs. 4.41% late Thursday. Just before readings were released on retail sales and producer prices, the 10-year had been down 4/32 to yield 4.5%.

The two-year note edged higher 2/32 of a point to yield 4.33%, narrowing the spread between the 2- and 10-year notes to a mere three basis points.

The 30-year bond ended the day up 31/32 to yield 4.52%, down from 4.59% in the previous session. The long bond had been down 9/32 before the morning economic releases. And the five-year rose 8/32 to yield 4.28%. Bond prices and yields move in opposite directions.

The December producer price index unexpectedly jumped 0.9%, vs. forecasts for a 0.4% increase. But the core component, which excludes food and energy prices, rose only 0.1%, vs. expectations for a 0.2% rise.

Traders focused on the downward trend in the core as the most significant element in the release.

"The bond market has recently had a very good spate of inflation readings, including today's core PPI reading," says Anthony Crescenzi, chief bond market strategist at Miller Tabak and


"The core rate hasn't shown a gain of more than 0.1% since July, so there's a trend there. And the PCE core deflator -- which is the Fed's chosen inflation indicator -- shows a similar trend, staying at 0.1% for the past six months."

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Crescenzi says lingering geopolitical issues - namely tension over Iran's nuclear ambitions -- also supported Treasuries ahead of a long holiday weekend. Equities are holding up fairly well, so it's not a big flight to safety, he says. But investors are positioning themselves in case of geopolitical problems over the long weekend. Treasury markets closed early Friday afternoon and U.S. financial markets are shuttered Monday in observance of Martin Luther King Day.

Not only could Iran affect next week's trade, the market will have to digest reports on the consumer price index, housing, regional sentiment numbers, industrial production and foreign purchases, all in a shortened trading week.

A rally on the long end could keep the curve flat or even cause another inversion between the yields on the two- and 10-year notes, i.e. that the yield on the 10-year note could dip below that of the two-year.

There is debate among traders and analysts over whether an economic slump necessarily follows an inversion, as was the case the last two times this part of the curve inverted. Others worry that a falling 10-year yield could ramp up housing market speculation and prompt the Fed to tighten more than is currently anticipated.

Fed officials, including Alan Greenspan, have suggested several reasons why the shape of the curve is less predictive, including the fact that inflation has remained remarkably quiet, even with strong economic growth and high energy prices.

Furthermore, the march of globalization has eroded the Fed's influence over long-term rates: slow growth in Europe and Asia has made Treasuries unusually attractive for overseas investors who recycle the dollars we spend on their cheaper goods back into the U.S. economy

The morning's other economic release showed disappointing retail sales for December, with sales for the month up 0.7% vs. expectations for a 1% gain.

Consumer spending has been the backbone of economic growth, and the weaker-than-expected gain fueled speculation that the economy is well on its way to a soft landing.

But Michael Darda, chief economist at MKM Partners, says that the retail sales report was not as weak as it seemed at first glance.

"The series is volatile and the fourth quarter as a whole is still above historical norms," says Darda. "We didn't have the holiday season we had last year, but it wasn't horrible and it was still consistent with above trend growth. I'm not seeing any evidence of significant weakness outside of normal volatility."

Darda warns that bonds are still "extraordinarily overvalued relative to stocks" and bond market action could therefore be very volatile since there is so little risk priced into the market. "Stocks are priced for a disaster scenario, so your risk going into stocks is far lower," he says. "Based on risk reward, everything needs to go right for bonds."

A tremendous amount of new debt has weighed on the market in the last few sessions. The Treasury sold $13 billion in five-year notes at a yield of 4.37% on Wednesday, and the notes yielded 4.31% today. Thursday saw a $9 billion auction of 10-year Treasury Inflation Protected Securities, or TIPs, which drew a yield of 2.025 percent. The notes traded at a yield of 1.98% today.

This week also saw a record $35 billion in corporate issuance. Crescenzi says that the market typically sees an average $2.5 billion in corporate debt issues a day, or $12.5 billion a week.

In the next four weeks, the government will raise about $100 billion by selling two-, three- and 10-year notes and 20-year inflation protected notes. It will also sell the 30-year bond for the first time since August 2001.