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Greenspan Speaks, and Bonds Exhale

The market now appears sure that the Fed will hike interest rates by 25 basis points at the June 29-30 FOMC meeting, but is doubtful that more rate hikes will follow.

If the bond market ever got enough advance word that a hike in interest rates was coming, it would be like taking candy from a baby. Today the market got its candy -- all of it.

Federal Reserve

Chairman

Alan Greenspan

said in eagerly awaited testimony

today that "modest preemptive actions" by the Fed can "obviate the need of more drastic actions at a later date that could destabilize the economy." The bond market responded with a massive relief rally, dropping the yield on the 30-year Treasury bond below 6% and the two-year note's yield to 5.5%. The market now appears sure that the Fed will hike interest rates by 25 basis points to 5% at the June 29-30

FOMC

meeting, but is doubtful that more rate hikes will follow.

"I think most people are looking at 25 basis points in June but afterward the Fed is going to return to the neutral stance and wait and see," said Ken Fan, bond strategist at

Paribas Capital Markets

.

The two-year Treasury note, the cash instrument that trades based on expectations for monetary policy, was up 5/32, dropping the yield 13 basis points to 5.51%, a level it deemed fair relative to a potential 5% fed funds target. Lately the 30-year Treasury bond was up 1 6/32 to 89 31/32 as the yield fell 14 basis points to 5.98%.

"Basically, the market heard what they anticipated they knew, and they also didn't hear that we're going to have more tightening down the road," said Fan. "Maybe that's going to pop up once we're done with the June meeting."

Greenspan said today before the

Joint Economic Committee

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that while the labor-market tightness has not led to higher prices and higher wages, it could do so in time. The chairman concludes that the approximate 4% economic growth over the last few years rate is unsustainable without a rise in inflation. What's unsustainable, he said, is the 1 percentage point of this growth he attributes to the diminished availability of workers.

The threat of wage-induced inflation is part of the reason the market is not ruling out the possibility that the Fed may raise rates at the next Fed meeting Aug. 24. The September fed funds futures contract, a key indicator of the market's view of future policy, is higher today, discounting less of a chance of two rate hikes by that month. The September contract is yielding 5.15% today, discounting a 60% of another rate hike. Yesterday's closing yield was 5.17%, or a 68% chance of a second rate hike.

Yesterday's anecdotal

Beige Book reported that wage pressures were increasing in many areas of the country. As of yet, statistical releases such as the quarterly

Employment Cost Index

or the

employment report's

average hourly earnings component have not confirmed the reports contained in this survey.

"He said, 'We're going to change policy on where we want to be a year from now,'" said Joel Naroff, president of

Naroff Economic Advisors

. "It doesn't mean anything if the ECI numbers are going to be okay now but if

the Fed believes they're not going to be okay a year from now, that's how they're going to determine their policy."

Greenspan himself suggested that a second hike in August isn't unthinkable with his discussion of reduction in the funds rate by 75 basis points. The chairman cast last year's series of rate cuts as necessary to combat the financial crisis and said they've since "ceased to be necessary." However, the Fed "chose to maintain the lower level of the funds rate" because of the lack of inflationary evidence.

"People forget that we're at 4.75% not because the economy was having problems but because the world needed liquidity -- the need for that liquidity is largely gone," Naroff said.

The July contract's current yield is 5%, fully pricing in one interest rate hike by July 1.