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Long Bond Surrenders Gains, Short Yields Soar on Tightening Bias

A change in the Fed's monetary policy stance wasn't fully priced in, it turns out.

The long Treasury bond was little changed at the end of the day after the


monetary policy committee

announced that it had adopted an official bias in favor of a higher fed funds rate.

But indicating that the bias change, which says that the Fed is inclined (but by no means certain) to raise the fed funds rate in the months ahead, was less than fully priced into the market, the bond gave back a pre-announcement gain of more than half a point. And shorter-term notes, whose yields are more closely linked to the fed funds rate, got whacked.

The afternoon's price action,

Warburg Dillon Read

Treasury market strategist Mark Mahoney said, "said that there were far fewer people expecting the Fed to move to a tightening bias than we thought. We thought that any reasonable person would've expected the Fed to adopt a tightening bias, so we thought it would go up when they did."

The benchmark 30-year bond, which before the 2:15 p.m. EDT announcement traded up as much as 19/32, ended the day down 1/32 at 91 1/32, its yield unchanged at 5.89%. The

early gains were due to a much-weaker-than-expected April

housing starts

report, and to short-covering by traders who thought the market might rally if the Fed did nothing.

The two-year Treasury note, however, finished down 4/32, lifting its yield 7 basis points to 5.36%. The difference in yield between the two issues, a popular measure of the slope of the yield curve, flattened to 53 basis points from 60 yesterday. With the Fed in a tightening posture, Mahoney said, the short end of the yield curve "could go up, but it's certainly going to lag the long end in any rally."

The day's action also included "a really big seller of

five-year notes," Mahoney said. The five-year note finished down 8/32, its yield rising 6 basis points to 5.57%.

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After concluding its third meeting of the year, the

Federal Open Market Committee

released the following

statement: "While the FOMC did not take action today to alter the stance of monetary policy, the Committee was concerned about the potential for a buildup of inflationary imbalances that could undermine the favorable performance of the economy and therefore adopted a directive that is tilted toward the possibility of a firming in the stance of monetary policy.

"Trend increases in costs and core prices have generally remained quite subdued," the statement continued. "But domestic financial markets have recovered and foreign economic prospects have improved since the easing of monetary policy last fall. Against the background of already tight domestic labor markets and ongoing strength in demand in excess of productivity gains, the Committee recognizes the need to be alert to developments over coming months that might indicate that financial conditions may no longer be consistent with containing inflation."

People who didn't expect the bias shift reasoned that the FOMC was unlikely to make any changes based on a single month's worth of above-trend inflation data. The April

Consumer Price Index

, released

last Friday, posted some of the biggest numbers in years. People who correctly predicted the bias change countered that the Fed had more to protect in the credibility department than it had to lose by taking an action which, after all, is not certain to lead to an actual rate change.

"The announcement confirmed what the trend had been telling us for the past few days -- that the Fed was moving toward a tightening bias," said Christopher Fitzmaurice, co-head of government bond trading at

Salomon Smith Barney

. "They could

raise the fed funds rate 25 basis points any time between now and a month or two from now." The fed funds rate, the Fed's target for the bank overnight lending rate, has been 4.75% since November, when the central bank delivered the last of three 25-basis-point rate cuts in a span of less than two months.

A bias change was the highest-probability outcome of today's meeting, Fitzmaurice said. The selloff in reaction to it represented a pricing out of all the other possible outcomes, however minuscule their probability: no announcement, an actual tightening, an easing bias and an actual easing.

This was the first time the FOMC announced a change in its official bias. Previously, it only made an announcement when it changed its the rate itself. Changes in bias were occasionally publicized by leaking them to journalists. Then, at its Dec. 22 meeting, the

minutes of which were released in early February, the committee decided "on an infrequent basis" to announce bias changes "on those occasions when it wanted to communicate to the public a major shift in its views about the balance of risks or the likely direction of future policy."