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Fed's Neutral Bias Surprise Sends Yields Tumbling

Now the focus turns to the economic data that could skew the odds back in favor of another rate hike in August.

The

Fed's

unexpected decision to drop its official bias in favor of raising the fed funds rate lit a fire under Treasuries in the final hour of the trading day. Most Wall Street economists had expected that the Fed would leave its tightening bias in place.

So even though Fed policymakers raised the fed funds rate from 4.75% to 5% -- a move everyone expected -- the benchmark 30-year Treasury bond rallied as much as 1 20/32 after the 2:15 p.m. EDT announcement, and ended the day up 1 5/32 at 90, trimming its yield 7 basis points to 5.97%. It was the long bond's first close below 6% since June 18.

Shorter-maturity notes, whose yields have a closer relationship to the fed funds rate, rallied even harder. The two-year Treasury note, for example, hopped 9/32 to 100 12/32, slashing its yield to 5.55% from 5.70%.

The rate hike, which Fed Chairman

Alan Greenspan

telegraphed in congressional

testimony on June 17, was the

Federal Open Market Committee's

first policy action since November, when it trimmed the fed funds rate from 5%, and the first rate hike since March 1997.

The Fed's bias is its view about how it might conduct monetary policy in the near future, and this was the first time since adopting a broader disclosure policy in December that policymakers have revealed their bias in conjunction with a rate action.

The

statement announcing the hike and the bias change said: "Owing to the uncertain resolution of the balance of conflicting forces in the economy going forward, the FOMC has chosen to adopt a directive that includes no predilection about near-term policy action."

Even though historically the FOMC more often than not has reverted to neutral after taking a rate action, most Fed watchers expected the committee to leave the tightening bias in place this time. Announcing a neutral bias at this stage, they reasoned, would signal a smaller likelihood of a second rate hike at the Fed's next meeting on Aug. 24 than actually exists.

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ABN Amro

was one of the few firms to correctly predict that the Fed would revert to a neutral bias, and the firm is currently predicting that the Fed will stand pat in August. "If you look at the leading indicators of inflation, there are some pressures in the background, such as tight labor markets, but you don't see most of those things turning up yet," market strategist Charles Reinhard explained. They include the supplier deliveries component of the

Purchasing Managers' Index

, the June edition of which comes out tomorrow, and industrial materials prices, he said.

The Fed made clear in the conclusion of its statement that additional rate hikes can't be ruled out. "The Committee, nonetheless, recognizes that in the current dynamic environment it must be especially alert to the emergence, or potential emergence, of inflationary forces that could undermine economic growth," it said.

Still, Treasuries rallied on the unassailable logic that a Fed with a neutral bias is less likely than a Fed with a tightening bias to hike rates again in August. The fed funds futures contracts traded on the

Chicago Board of Trade

reveal exactly how much less likely. Yesterday, the September futures were discounting a rate of 5.20%, or an 80% likelihood of a second rate hike in August. At the end of today, they discounted a 5.13% rate, or a 52% chance of a second hike.

Now the focus turns to the economic reports that will tip the balance between now and then, two of which are due out this week. Tomorrow brings the June Purchasing Managers' Index, the key manufacturing indicator. Today, the June

Chicago Purchasing Manager's Index

, a regional manufacturing indicator, unsettled the Treasury market in the early hours with a strong reading of 60, up from 57.9 in May. And Friday brings the June

employment report

.

"Every piece of data is going to be scrutinized to determine if they will go in August or not go in August," said Marilyn Schaja, money-market economist at

Donaldson Lufkin & Jenrette

. "They left it wide open."