Increasing Rate-Hike Fears Send Bonds Tumbling

A big drop in blue-chip stocks wasn't enough to overcome rumors of imminent Fed action.
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On paper, the losses don't look terrible. In reality, the market's poor performance is an extension of the pattern seen earlier this week: Other markets are stumbling, and bonds don't take advantage due to worries about higher interest rates. Monday and Tuesday, it was the flight from corporate and emerging bond markets; today it's the U.S. equity markets. It doesn't matter, though -- for bonds, it's all about the

Fed

.

"The Fed has a loaded gun, and there's nothing feared more by a portfolio manager in the Treasury market than

that," said Michael Krauss, chief technical strategist at

Chase Securities

.

The damage was first done in the two-year note, the maturity most sensitive to changes in monetary policy. It spread to the rest of the curve in the afternoon, when two different reports suggested that the Fed will hike rates at the June 29-30

Federal Open Market Committee

meeting.

The two-year note was lately down 5/32 to 99 22/32, as the yield rose to 5.42%, or 6 basis points, from 5.36%. The 30-year Treasury bond fell 21/32 to 91 17/32, boosting the yield 5 basis points to 5.85%.

Since the Fed adopted a bias toward raising interest rates at the May 18 FOMC meeting, the market's been riding high on a deep depression. Emerging market bonds and stocks sold off sharply earlier this week on the fear that higher rates would undermine recovery in the global markets, and bonds couldn't rally. Fears of diminished liquidity also caused a selloff in the corporate markets. Wednesday, new agency and corporate bond offerings increased their offered yields to attract enough buyers.

"The fact that the bond market couldn't rally on what normally would have been positive events was an important sign that the market was running out of buyers," said Krauss.

Today, it was the stock market's turn to freak out completely.

Medley Global Advisors

, a consulting firm, released a report this morning suggesting a rate hike was coming sooner rather than later. The prominence this report received on television today seemed to bother the already skittish equity market. The report suggested the Fed intends to be preemptive rather than reactive, although it did not say the Fed would hike rates tomorrow, which was rumored in the market today, according to a source familiar with the report. The

Dow

lost 235 points today, and the other indices also finished in the negative, but the bond market didn't find any support from that weakness.

"The prospects of a Fed tightening are the common cause for both problems," said Charles Reinhard, market strategist at

ABN Amro

.

Market News'

Fed watcher, Steven Beckner, poured extra lighter fluid into the grill today in an article that also intimates the Fed may hike rates soon. Seeing as how this is the market's main concern as it is, it's hard to tell what kind of affect this article had.

But as the market becomes more fearful of an interest-rate hike, it lessens the potential impact of that hike when it actually happens. Today, the July fed fund futures, traded on the

Chicago Board of Trade, closed at 95.07, reflecting a 70% chance of a 25-basis-point tightening by the Fed at the June 29-30 meeting. Last week, the July contract was only pricing in a 50/50 chance of a move.

The rise in the two-year note's yield is also a good indicator of the market's fear of a rate hike. The two-year note has widened by 13 basis points since May 14, when the

Labor Department

reported a 0.7% rise in the

Consumer Price Index

in April. The report changed the market's thinking, into believing the Fed would indeed adopt a tightening bias.

Since that day, the yield on the 30-year bond has actually slimmed by 8 basis points. The narrowing, or flattening, trend shows that the market's anxiety over a potential interest-rate hike has increased, but that it's reserving judgment over rising inflation until more economic data supports it. The difference between the two today fell to 43 basis points from 55 on May 18.

"You have to think that's going to continue to be the bias here," said Bill Kirby, co-head of government securities trading at

Prudential Securities

. "There's been more sellers in the front end."

A Tight Squeeze
The spread between the two-year note and 30-year bond

Tomorrow the market will get one of its first tastes of forward-looking economic data. The

Chicago purchasing managers' index

, a survey of sentiment in the Midwest manufacturing sector, is released. In April, this figure read 63.3, which indicates a sense of optimism in manufacturing. Were that to continue, it would bolster the case for higher interest rates.

First-quarter

GDP

was revised downward to 4.1% from 4.5% today, but the market wasn't paying attention. The report's inflationary component, the implicit price deflator, was unchanged at 1.4%.