Treasuries rallied today in spite of some stronger-than-expected economic data, with long-maturity issues outperforming short-maturity ones for much of the day ahead of tomorrow's expected rate hike by the Fed.

With the Fed poised to raise the

fed funds rate from 6% to, forecasters presume, 6.5%, it makes sense that investors would prefer long-maturity instruments. Short-maturity yields generally stay in the vicinity of the fed funds rate, but longer-maturity instruments are valued based on inflation expectations. When the fed funds rate goes up, investors may lower their inflation expectations, giving intermediate- and long-term Treasuries a boost.

The benchmark 10-year Treasury note gained 16/32 to 100 10/32, dropping its yield 7.3 basis points to 6.452%. But the two-year note gained 5/32 to 99 4/32, trimming its yield only 5.6 basis points to 6.880%.

The 30-year Treasury bond rose 21/32 to 101 8/32, lowering its yield 5 basis points to 6.156%. At the

Chicago Board of Trade

, the June

Treasury futures contract added 18/32 to 94 2/32.

Tony Crescenzi, chief bond market strategist at

Miller Tabak

, said yield-curve trading, or betting on the relationships between short- and long-maturity issues, was a dominant trend in Treasuries today. As traders bought long-term issues against short-term ones, the difference in yield between the two- and 30-year Treasuries approached the 18-year low of minus 73 basis points it reached on May 1, Crescenzi said. That spread ended the day at around minus 72 basis points.

The yield-curve-flattening trend that has been in place for much of this year has also been driven by the

Treasury Department's

buyback program, in which federal government surplus funds are being used to buy old, long-maturity issues -- its most expensive debt -- back from investors willing to tender them. The fact that the government wants to buy long-maturity issues has inflated their prices relative to shorter-term ones. That dynamic is also in play this week, with the department planning to announce the details of its next operation on Wednesday, and to execute it on Thursday.

In addition, Crescenzi said, the market may have "overly discounted" the possibility of a 50-basis-point fed funds hike tomorrow, making today's action corrective.

Meanwhile, traders may have been making bets on the more suspenseful elements of tomorrow's session -- the statement that accompanies the

Federal Open Market Committee's action, and the April

Consumer Price Index.

While a rate hike is assured, and while most forecasters expect the FOMC in its statement to characterize the economy as at risk of higher inflation, the possibility that it will say the risks to the economy are balanced between higher inflation and too-slow growth has energized some Treasury market participants,

Merrill Lynch

government bond strategist Jerry Lucas said.

"The market has rallied going into recent Fed hikes, hoping it's the last," Lucas said.

Regardless of which way the committee characterizes the economy tomorrow, the difference between short- and long-term Treasury yields will collapse further, he said. If it highlights the risk of inflation ("admitting they're behind the curve"), Lucas thinks both short- and long-term yields will rise, with short-term yields rising more. But if it surprises the market with a statement that calls the risks to the economy balanced, long-maturity issues could rally substantially, as short-term yields rally less, he said.

As for the CPI, it is expected to experience the gentlest rise in months thanks to last month's steep drop in gas prices.

Economic Indicators

The industrial economy was stronger than expected in April, according to the

industrial production report released this morning (a few minutes prematurely after a wire service inadvertently broke the Fed's embargo on the news). Industrial production rose 0.9%, vs. an average forecast of 0.7%.

Industrial production is now rising at a 6.1% rate, vs. 3.7% for industrial capacity. If this gap persists, the consequences could be inflationary.

In April, the capacity utilization rate, which measures anti-inflationary slack in the industrial economy, found less of it, rising to 82.1%, the highest since May 1998, from 81.7%. It had been forecast to rise to 81.8%.

In other news, the

Housing Market Index rose to 63 in May from 62 in April. It is down from a December 1998 peak of 78.

Currency and Commodities

The dollar gained against the yen and the euro. It lately was worth 109.28 yen, up from 108.38. The euro was worth $0.9107, down from $0.9197. For more on currencies, please take a look at


Currencies column.

Crude oil for June delivery at the

New York Mercantile Exchange

rose to $29.92 a barrel from $29.62.


Bridge Commodity Research Bureau Index

fell to 219.98 from 220.74.

Gold for June delivery at the


fell to $276.40 an ounce from $276.90.