New Economic Outlook Reshapes Treasury Market - TheStreet

The wrenching changes that got underway in the bond market earlier in the week intensified on Friday, signaling a new outlook on the economy and interest rates.

Other forces are at work too, but bond market professionals say the new structure of Treasury yields indicates broad agreement that the

Fed is finished hiking interest rates, and may even have to lower the

fed funds rate sometime next year.

Short-term Treasury yields improved a bit today, and ended the week slightly lower than when the week began. But the benchmark 10 year note's yield tacked on several basis points as its price fell, putting it 10 basis points higher on the week. The damage to the 30 year bond was even worse. As its price kept falling, its yield ended the week 20 basis points higher. The 30 year bond's yield is now higher than the 10-year note's yield for the first time since January.

The outperformance of short-term bonds at the expense of long-term ones is generally associated with the view that the Fed's next move will be an interest-rate cut rather than a hike.

The benchmark 10 year Treasury fell 11/32 to 99 10/32, lifting its yield 4.6 basis points to 5.893%.

The 30 year bond sank 1 6/32, hiking its yield 8.1 basis points to 5.899%, the highest since July 19. Just two weeks ago, the long bond's yield stood at 5.660%, its lowest level of the year.

At the

Chicago Board of Trade

, the December Treasury futures contract fell 26/32 to 98 10/32.

Economic data released this morning were friendly, but did not fully explain the day's price action.

The

Consumer Price Index

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) fell 0.1% in August, vs. an average forecast that it would rise 0.2%. The less inflation the better as far as the bond market is concerned, but it couldn't get too excited by this news. A 2.9% drop in energy prices was entirely responsible for the drop in overall prices. The core CPI, which excludes food and energy prices and is a more stable barometer of inflation trends, rose 0.2%, in line with the average forecast. Also, the sharp rise in oil prices over the last month is expected to make September's inflation reports considerably less lovable.

Industrial production

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) rose 0.3% in August, vs. an average forecast it would be unchanged. But here too an outsized result in one category -- a 4% rise in utility output -- offset regular results in other categories.

The massive selling of long-maturity Treasuries, hoisting their yields relative to those of shorter-maturity issues, is being driven by three interrelated ideas, bond market professionals say.

First, investors have concluded that the Fed will probably not hike interest rates again, and may even resort to lowering them at some point next year if economic growth slows too much. As long as the Fed is inclined to raise interest rates, investors can stomach long-term bond yields that are lower than short-term ones. Interest-rate cuts, on the other hand, are inherently inflationary because they stimulate the economy. Expectations of higher inflation lead bond investors to push up long-term yields relative to short-term ones.

"More people have reached the conclusion that growth is likely to slow," making the Fed unlikely to raise rates,

Dresdner Kleinwort Benson

senior market economist Kevin Logan said. "In fact, sometime next year the Fed will be easing. We're penciling it in for June."

Rising energy prices are a second factor in the shifting relationship between short- and long-maturity Treasury yields, said David Connors, head of government bond trading at

Credit Suisse First Boston

. Crude oil has been selling for more than $35 a barrel for the first time in 10 years. That is potentially inflationary, encouraging investors to demand higher yields on long-term bonds. But it also has the potential to stall economic growth, as it did 10 years ago.

Finally, bond investors have started to consider how the presidential election might affect government financing policy, Connors said. The Clinton administration has been using the budget surplus to pay down the national debt by buying back Treasury securities from investors. Because the buybacks have focused on long-maturity issues, their prices have risen disproportionately.

That's not certain to continue regardless of who captures the White House and Congress, but the prospect of Democrats winning both has bond investors envisioning more spending, smaller surpluses and fewer buybacks in the years ahead, Connors said. That takes scarcity value away from long-term Treasuries.

Corporate Bond Buyers Beware

Separately, famed bond investor

Bill Gross

had a sobering thought for corporate bond investors.

Gross, who manages the world's largest bond mutual fund for

Pimco

and has one of the best long-term performance records, has been arguing for months that the Internet economy will favor investors in government-backed bonds at the expense of investors in corporate bonds. At a time when hundreds of new companies are playing musical chairs, corporate bond investing doesn't pay enough to offset the occasional default, he says.

In his latest monthly commentary, published on Pimco's

Web site, Gross takes his case a step further, crediting

Barclays Capital

bond market strategist Tim Bond for the idea.

When a company defaults on its bonds, investors traditionally recoup what they can by liquidating the firm's assets, on which they typically have a claim. How's that going to work, Gross muses, in an Internet economy? "If corporate investment capital becomes increasingly defined by information and knowledge as opposed to railroad tank cars, then woe to be the creditor who tries to collect in the event of bankruptcy."

Economic Indicators

In other economic news,

real earnings

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) rose 0.1% in August, as the 0.1% drop in the CPI boosted the real value of average weekly earnings, which were unchanged for the month.

The

Consumer Sentiment Index

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chart) rose to a preliminary 108.8 in September from 107.3 in August.

Business inventories

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) rose 0.2% in July, considerably less than expected. But for the first time since February 1999, inventory growth outpaced sales growth, taking pressure off the economy to continue to produce goods at a rapid clip.

Currency and Commodities

The dollar fell against the yen and rose against the euro. It lately was worth 107.07 yen, down from 107.62. The euro was worth $0.8533, down from $0.8642. For more on currencies, see

TSC's

Currencies column.

Crude oil for October delivery at the

New York Mercantile Exchange

rose to $35.85 a barrel from $34.07.

The

Bridge Commodity Research Bureau Index

fell to 228.28 from 228.84.

Gold for December delivery at the

Comex

fell to $275.90 from $276.00.