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Fed's Tightening Bias Squashes Yield Curve

The long bond is rallying, but short notes are begging for buyers.

The yield curve is in free fall, thanks to

yesterday's shift by the


to an official bias in favor of higher short-term interest rates.

There are several ways to define the yield curve, but the most popular is probably the difference in yield between the benchmark 30-year Treasury bond and the two-year Treasury note.

On no economic news, the benchmark long bond lately was up 24/32 in price at 91 27/32, trimming its yield 6 basis points to 5.83%. The two-year note, meanwhile, was off 2/32, lifting its yield 4 basis points to 5.38%. As a result of the moves, the difference in yield between the two securities has collapsed to 45 basis points from 55 yesterday. And since last Friday, the curve has tumbled from 64 basis points. The low for the year is 43 basis points.

The massive flattening -- so far this year, the yield spread between the two issues has averaged 55 basis points -- is easily understood as a function of the Fed's move. Investors evaluate short-term yields in relation to the fed funds rate. By adopting a tightening bias, the Fed signaled that the fed funds rate has nowhere to go but up. The same is true, then, of short-term yields. Long-term yields are typically higher than short-term yields because investors demand compensation for inflation expectations. The lower their inflation expectations, the less compensation they need. And a higher short-term rate works to curb inflation worries.

"It's reflective of the Fed's change in bias,"

Thomson Global Markets

managing analyst Ken Logan said of today's price action. "The odds are that short-term rates are not going lower. They'll stay where they are or go higher."

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At the same time, "an attentive Fed is beneficial in the long run for bonds. They're going to be vigilant

for signs of rising inflation. They're not going to get behind the curve."

A widened spread between U.S. and foreign government bond yields (the U.S. yields are higher) is also driving the trend, as investors who buy both types pile into the U.S. Treasuries that look particularly cheap vs. Japanese government bonds,

Miller Tabak Hirsch

chief bond market strategist Tony Crescenzi said. The spread between the 10-year issues lately stood at 433 basis points, less than 30 basis points shy of a two-year high.

How far can the flattening go before we see profit-taking by traders who are capitalizing on the trend by owning the long end of the curve and shorting the front end?

"We may get short-term profit-taking because of the abruptness of the move, but until an all-clear is sounded for the short-end -- an all-clear would be a signal that a Fed tightening is no longer a threat -- 'til then, I think this trade will stay on," with the low for the year of 43 basis points as a target, Crescenzi said.

What could sound the all-clear? Chance weakness in economic data. A stock-market correction. A friendly May

Consumer Price Index

next month. Crescenzi's not holding his breath. "Short-term rates are going to stay high. The Fed will encourage it verbally and may act upon it, maybe by June 29," the next scheduled meeting of its monetary policy committee.