Fed Hopes and China Fears Lift Bonds

Comments by a Fed official support the view that additional rate hikes won't be necessary.
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The bond market ended the day modestly higher, thanks to comments by a

Fed

official suggesting interest rates won't be hiked again in August, and to a bit of nail-biting over the rising tensions between China and Taiwan.

The benchmark 30-year Treasury ended the day 15/32 higher at 91 5/32, shaving 4 basis points off its yield to 5.88%. Shorter-maturity notes outperformed -- befitting a Fed-inspired rally, befitting a flight-to-quality rally, and especially befitting a rally driven by both of those forces. At the short end of the Treasury curve, the two-year note rose 3/32, slashing its yield by 6 basis points to 5.47%.

"It was mostly the

Broaddus

comments," said Matt Frymier, a note trader at

Banc of America Securities

in San Francisco. "They sort of took the Fed out of the picture."

Richmond Fed

President Al Broaddus is quoted in today's

Washington Post

on the subject of the June

Consumer Price Index

, released yesterday.

The CPI, the government's broadest measure of inflation, was unchanged in June. It was also unchanged in May. This came as a great relief, since in April, the CPI rose 0.7%, its biggest increase since October 1990. The April number triggered a selloff in the bond market, as traders priced in the possibility that the Fed would go on a rate-hiking binge in order to bring the inflation rate under control.

"I'm enormously comforted by this most recent number and the one before it," Broaddus told

Washington Post

veteran Fed reporter

John Berry

. "I was worried by the number in April. I knew it might be an anomaly, but now it's clear that it was."

Broaddus isn't currently a voting member of the Fed's monetary policy committee, the

Federal Open Market Committee

. But he's viewed as one of the most hawkish Fed officials -- one of the least tolerant of inflation risk -- so his free-and-easy sentiment counts double. "What are the dovish people thinking?" Frymier cracked.

At the same time, the simmering dispute between China and Taiwan stoked a bit of demand for Treasuries, especially the short-term variety, even as the dollar, the world's safe-haven currency, meandered. Taiwanese

President Lee

, who's fending off a reelection challenge from a nationalist party, tried to outflank them earlier this week by suggesting that Taiwan and China were separate countries, as opposed to separately governed parts of the same country. That angered Beijing, which made a point to disclose for the first time the known fact that it has the neutron bomb, the

New York Times

reported today.

Mellon Bank

currency strategist and

TSC

contributor

Marc Chandler

, noting that the last time Taiwan held elections, in 1996, China lobbed missiles over the island, rates the prospect of a conflagration "highly unlikely. As long as China sticks to saber rattling, they will have the world" -- which doesn't recognize Taiwan as a nation -- "on their side."

But on top of the friendly CPI readings, evidence that U.S. economic growth slowed moderately during the second quarter, and the flare-up of concern about Latin American finances earlier in the week, the Chinese tension made for just one more reason to buy Treasuries today, Chandler said.

Looking ahead to next week, the focus is on Fed Chairman

Alan Greenspan's

semiannual

Humphrey-Hawkins

congressional testimony on the economy and monetary policy. It's slated for Thursday, and this afternoon the hour was pushed back to 11 a.m. EDT.

Market participants are hoping for a signal about the next FOMC meeting on Aug. 24. Many were surprised when, at the last meeting on June 29-30, the Fed dropped its official bias in favor of raising rates.

Camps have formed along the following lines: People who think the Fed won't hike again in August point to the recent benign inflation numbers and the neutral bias. People who think they might say it's future inflation readings the Fed's going to be thinking about.

"The inflation numbers have been better than expected but the demand-side data hasn't softened at all,"

Deutsche Bank

senior economist Joe LaVorgna said. "That's why they hiked in the first place. The issue is where the economy's headed, and I think the future there is pretty bright."