Improving Fed Outlook Lifts Bonds, Flattens Curve

And fearlessness about inflation wrecks the TIPS auction.
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Bond prices finished mixed today, as long-dated paper gained while short-dated securities slipped, further reversing the sharp steepening of the Treasury yield curve that occurred during the last week and a half of March.

Driving the action, market watchers said, is the combination of growing conviction that the


is unlikely to raise interest rates in the months ahead, and the failure of the ongoing war in Yugoslavia to unnerve investors on a large scale.

Rising optimism about the interest rate outlook is giving investors the necessary courage to buy long-dated Treasuries, while their indifference to the war is reversing the flight-to-quality buying of short-dated paper that occurred as the hostilities got under way. A disinflationary drop in oil prices also supported the long end. The May crude futures contract traded on the

New York Mercantile Exchange

shed 76 cents to 16.05, its lowest close in nearly two weeks.

The benchmark 30-year Treasury bond finished the day up 5/32 at 96 6/32, dropping its yield a basis point to 5.51%. But the two-year Treasury note ended the day down 1/32, lifting its yield 2 basis points to 4.93%, in spite of two Fed coupon passes in which the central bank bought short-dated paper. The Fed does coupon passes to keep the fed funds rate on target by injecting liquidity into the banking system.

As a result the difference between the two yields, a popular measure of the yield curve, flattened to 58 basis points from 61 on Tuesday. From March 22 to April 2, the curve steepened from 50 to 73 basis points.

"I'd view it as a convergence, rather than as the starting of a trend,"

Paribas Capital Markets

bond strategist Ken Fan said of the recent curve flattening.

With no market-moving economic indicators on the calendar, what trading there was (volume was 38.9% below average for a second-quarter Wednesday at 3 p.m., according to tracker


) was focused on the interest-rate outlook, said David Connors, managing director at

Credit Suisse First Boston

. "I think we saw a continuation of what we've seen for the past couple of sessions," he said. "What's driving the long end is that shorts that were in place for the past two or three months are in the process of being unwound.

"The main reason," Connors continued, "is that we've shifted dramatically both in the market's perception of where the Fed's going, and market prices, since the crisis mode at the end of '98. The fear was that the Fed was moving more to a tightening bias and might in fact tighten by the end of this year by as much as 75 basis points," taking back last year's three 25-basis-point easings. But last week's meeting of the Fed's monetary policy committee, which produced no announced change of policy, "drove home to a lot of short positions that that might not happen. The Fed might be neutral, they might not be tightening, and the long end might be priced fine for expected monetary policy going forward."

Nonchalance about the inflation outlook might also explain the mediocre reception for the third auction of 30-year Treasury Inflation-Protected Securities today. The bonds, whose principal is indexed to the

Consumer Price Index

, outperform regular bonds when inflation is heating up. Today they got fewer bids than ever before, producing a bid-to-cover ratio of 2.10. "I think the guys wanted to see a clearer sign of inflation before they pick on these securities," Fan said.