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Gains Surrendered Ahead of Key Inflation Report

Tomorrow's May Consumer Price Index may write the agenda for the Fed in the months ahead.

After trading higher for most of the day, Treasuries surrendered their gains ahead of the release tomorrow morning of the May

Consumer Price Index

. The report, scheduled for release at 8:30 a.m. EDT, is seen as having the potential to trigger an explosive move either up or down, if it is either much weaker or much stronger than expected.

The benchmark 30-year Treasury bond, which traded up as much as 14/32 at 9:05 a.m., finished the day down 7/32 at 88 8/32, lifting its yield 2 basis points to 6.11%.

It's an indication that traders and investors are afraid the report will be stronger than expected.

The last CPI, for April, triggered a major selloff in the bond market on

May 14 when the increases were twice as large as expected and the largest in years -- the 0.7% increase in the overall CPI was the largest monthly gain since October 1990.

Now, with the


poised to hike the fed funds rate when it meets on June 29-30, market participants are worried about a second consecutive outsized gain -- one that would puncture the hope that the April number was a fluke. Another such number, analysts say, would virtually guarantee a June 30 rate hike and convert many people to the view that the Fed is likely to raise rates more than once in the months ahead.

"Last month, everyone understood that the data were noisy," said Anthony Karydakis, senior financial economist at

Banc One Capital Markets

. "Now there are no excuses for another outsized move." An outsized move, he said, would be any increase in the core CPI in excess of the 0.2% average forecast.

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A reading of that magnitude will make investors worry that the Fed has fallen behind the curve, making more than one rate hike necessary and even encouraging speculation that a 50-basis-point rate hike is possible on June 30, Karydakis said. Treasury prices would at least revisit their lows of Friday, Karydakis said. For the long bond, Friday's closing price corresponded to a yield of 6.16%, the highest in a year and a half.

Of course, that's not the only scenario. The CPI might be in line with expectations or it might be weaker. In any case, the bond market's reaction will be dictated, market watchers say, by what course of action the numbers will dictate for the Fed.

Almost everyone in the Treasury market expects that the Fed will raise the fed funds rate from 4.75% to 5% at the end of the month. It would take an extremely weak CPI -- a down 0.1% or unchanged core -- to remove the air of foregone conclusion from the event, Karydakis said.

However, some people think that even a negative CPI reading won't stop the Fed from hiking on June 30. They reason that in recent speeches, Fed heads have been making the point that monetary policy needs to take a preemptive attitude toward inflation. The Fed "almost has to move at this point because of what they told the market," said Richard Schwartz, a portfolio manager at

New York Life Asset Management


Still, a weaker-than-expected CPI will probably trigger a rally in the bond market, taking the long bond's yield as low as 6%, Schwartz says. And so might an in-line report, reflecting relief that it wasn't stronger than expected.

But Schwartz says any rally tomorrow morning will probably fade as the day wears on, as today's did. Fed Chairman

Alan Greenspan

is slated to address the congressional

Joint Economic Committee

on Thursday at 10 a.m., and people will start to worry about what he might say.

Greenspan's testimony "will go a long way toward clarifying the market's thinking" on whether one or more rate hikes is the likelier scenario, Karydakis said.

That's assuming the numbers themselves aren't cause for worry. If they are, Schwartz says the long bond's yield could reach 6.25%. "Tomorrow's number," he said, "is likely to sway sentiment quite a bit in one direction or the other."