The Treasury market bled out Monday as early strength in stocks around the world lowered its defenses and then the leading indicator of the state of the manufacturing sector went for the jugular.

The benchmark 30-year bond ended the day down 1 15/32 at 101, lifting its yield 9 basis points to 5.18%, the highest since Jan. 12. Shorter-maturity notes fared only slightly better. The two-year note lost 4/32, lifting its yield 7 basis points to 4.65%. The difference between the two yields widened to 53 basis points from 51 on Friday.

Expectations as reported by

Reuters

The

Purchasing Managers Index

, the manufacturing indicator, wasn't exactly the picture of strength. But it was so much less weak than economists were expecting, and that has such potentially profound implications for the economy as a whole, that bond traders started rethinking their assumptions about how much lower interest rates can realistically be expected to go.

The PMI, which signifies growth when it's over 50 and slowdown when it's under 50, rose to 49.5 in January from 45.3 in December. Economists surveyed by

Reuters

had predicted it would rise to just 46.7.

Besides being a large jump, this was the index's second consecutive rise since first dipping below the 50 line in June. That has Treasury market analysts theorizing that the worst is over for the manufacturing sector, which has been pummeled by the Asian crisis, which sapped foreign demand for U.S. products. Only manufacturing has held back U.S. growth in the last year. If it's on the rebound, they reason, there's little basis for predicting a slowdown of the magnitude that could prompt the Fed to cut interest rates this year.

"Manufacturing historically has been the thing that tipped the scale one way or the other," said Tony Crescenzi, chief bond market strategist at

Miller Tabak Hirsch

. "The economic calendar is skewed heavily toward manufacturing indicators, and when people see strength in that category they project forward what they to expect to see for the rest of the month. And they don't like it."

Crescenzi thinks today's move is just the beginning of an extended Treasury market rout that will gradually push the yields of all notes over the 4.75% fed funds rate. Today, all notes (the two-, five- and 10-years issues) still yield less than fed funds. Investors will generally only hold notes at yields below the fed funds rate if they believe the fed funds rate is destined to fall. The strategist argues that today's economic news -- combined with other recent reports that have testified to the economy's strength -- make the Fed more likely to raise interest rates than lower them in the months ahead.

"This is simply an economy that's outperformed anyone's expectations, and any rate cut hopes are going out the window," Crescenzi said. "Now people are talking about a tightening bias tomorrow. That's something that might be leaked eventually, and the market's pricing in that possibility." The Fed's monetary policymaking

Federal Open Market Committee

convenes for its first meeting of the year tomorrow and Wednesday, and while the committee is almost universally expected to leave the fed funds rate unchanged, Crescenzi raised the possibility that policymakers would shift their official bias from neutral to favoring a higher rate. The bias isn't announced, but committee members have been known to leak it in order to guide the markets.

Today's market action wasn't entirely about the Purchasing Managers Index, however,

Morgan Stanley Dean Witter

chief money-market economist Bill Sullivan pointed out. The long bond was down half a point before it ever saw that report, which is released at 10 a.m., as European stock markets and the

S&P 500

futures contract surged in pre-market trading.

Sullivan, whose economic forecast for this year is among the most bearish in the industry, also says that the Treasury market is particularly vulnerable in the days leading up to the quarterly refunding. The Treasury's quarterly sale of new five-, 10- and 30-year notes and bonds takes place next week. "The market always trades cautiously ahead of a supply challenge," he said. In addition, he noted, Treasury market volume was about 25% below average today, and thin volume exaggerates the size of price swings.

And while not denying that the January Purchasing Managers Index raises the possibility that manufacturing's worst days are behind it, he thinks there's a sound basis that the Fed will maintain its neutral bias at this week's meeting. Notwithstanding the rebound in Brazil's stock market, the country's recent devaluation "is a reminder that the emerging market crisis is not really over," he said. The threat of a U.S. rate hike this year "would damage the prospects for recovery."

At the same time, Sullivan said, while the economy remains strong, there's been no sign inflation is accelerating. In fact, it's faded further, pushing the so-called real fed funds rate -- the fed funds rate minus the inflation rate -- higher. "Monetary policy has been tightening of its own accord as inflation pressures diminish," Sullivan said. "That's the loud and clear message attendant to every data series we've seen."

Expectations as reported by

Reuters