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Overbooked Flight to Quality Carries Bond Yields to Fresh Lows

Was there a lovelier investment in the world Thursday than the two-year Treasury note? Thanks to the headlong rush out of domestic stocks and most foreign investments, that paragon of safety and liquidity soared in value. Had you bought it at the monthly auction Wednesday, where it sold at par ($1,000) to yield 5.125%, you would have seen its price rise by $3.75 the next day, as its yield dropped to 4.91%.

Of course, the rally in Treasuries was not limited to the two-year note. Rising prices carried the benchmark 30-year bond's yield to a fresh low of 5.34%, as its price rose 1 5/32 to 102 10/32. And the more heavily traded 10-year note rose a full point to 104 5/32, dropping its yield to 5.07%, a level that mortgage experts have said could trigger a huge wave of mortgage refinancings.

But after Japan's


sank to its lowest close since August 1992, and as rumors swirled that with Russia on the brink of economic collapse Yeltsin will step down, and as

stocks sold off in dramatic fashion, short Treasury securities were far and away the best performers. The difference in yield between the two-year note, the shortest of the bunch, and the 30-year bond, the longest, exploded to 42.6 basis points from 30.6 on Wednesday.

The preference for short-term instruments is simply the flight to quality taken to its logical extreme. Demand is focused on the asset class that at least guarantees return of principal, if not return on principal. Within that class, investors are after the instruments that will retain the most of their value in the event that the forces currently driving people into Treasuries suddenly go into reverse. "The safest thing to own,"

American Century

bond portfolio manager Dave Schroder said, "is a short-term debt instrument of a country with a stable currency." Though the dollar weakened against the yen Thursday on intimations by Japanese finance officials that an intervention to support the yen is in the offing, slipping 1.97 yen to 142.23, it's got lots more room to fall before anyone will pick a fight with it.

In other words, the steepening yield curve signifies that the same investors who are putting money into bonds have not much confidence that money is going to keep flowing into bonds. As

Moody's Investors Service

chief economist John Lonski put it: "At this point in time a lot of the movement in securities prices in the U.S. is being driven by raw emotion, and is thus susceptible to wide swings to the extent the psychology changes."

At the same time, Lonski says there's no reason to think this is as high as bonds can go. Even though all bond yields are now below the 5.5% Fed-funds rate, the Fed's target for the overnight bank lending rate, and the domestic economy is strong, "it's premature to say that the situation is going to stabilize globally quickly enough that we're close to a bottom for bond yields."

The argument continues to be between people like Schroder -- who won't buy much at these levels because they remain convinced that the funds rate is roughly where it belongs, and that bond yields can't go much further below it in the near term -- and people willing to bet on a Fed-funds cut.

In Lonski's mind, while the economic fundamentals don't call for a rate cut, it's conceivable that the Fed would trim Fed-funds even before its next meeting on Sept. 29 in response to a huge drop in stock prices. "If the


were to go down 750 points, I'm pretty sure you'd see Fed-funds lower by day's end" in a move "intended to reassure investors about the Fed's willingness to insure a supply of liquidity," he said. The fact that all bond yields are below the target rate gives the central bank "a larger amount of maneuverability," Lonski says. "No investor is going to say the Fed is acting rashly -- that a

rate cut shows their credibility as an inflation-fighter is being strained."

Perhaps the only unambiguous fundamental reason for buying bonds on Thursday -- the drop by the

Commodity Research Bureau Index

to a fresh 12-year low of 196.24 -- was outnumbered by data that threaten higher inflation.

Expectations as reported by Reuters

The Commerce Department released its second of three estimates of second-quarter

gross domestic product

, and it was higher than the first. The economy grew 1.6% during the quarter, the government now says, not 1.4%. Economists surveyed by


had expected a revision to 1.5%. The number was revised higher chiefly because the trade deficit was smaller than originally measured, $246.3 billion, not $252.9 billion. Offsetting the positive effect of the smaller deficit, businesses built inventories at a slower pace than originally estimated, $39.1 billion a year, not $44.7 billion. The report's main measure of price inflation during the quarter went unrevised, at 0.8%.

The Labor Department's weekly tally of first-time claims for unemployment insurance dropped from 303,000 to 297,000, its lowest level since April 11. The new four-week average, 302,750, is the lowest since Aug. 9, 1997.

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APICS Business Outlook Index

, a manufacturing indicator which signals growth above 50 and slowdown below 50, rose to 50.8 from 49.1, remaining within the range its inhabited for the last two years. And the

Help-Wanted Index

, a labor market indicator, rose a point to 91, not far below its March peak at 93.

On Friday, traders will at least glance at three economic reports as they watch the stock indices: July

personal income and consumption

, the August

New York Purchasing Managers Index

and the August

Consumer Sentiment Index


Consumption growth has outpaced income growth for most of the last several months, but that's expected to reverse in July due to the

General Motors

(GM) - Get General Motors Company (GM) Report

strike. "The GM strike dented car sales, and car sales make up a pretty significant part of consumer expenditures,"

Lehman Brothers

economist Joe Abate said. Car and light truck sales dropped to a seasonally adjusted annual rate of 11.7 billion in July, from 14.9 billion, a record, in June. Consumption is expected to be unchanged in July, according to the


survey, while personal income is seen rising 0.3%. Forecasts for personal income are based on the monthly

employment report

. In the employment report,

average hourly earnings

have risen 0.2% for each of the last three months.

The New York PMI, officially known as the

New York Business Conditions Index

, has come off its highs but remains in historically strong territory. The July reading was 57.8, deep in the over-50 zone that signals growth.

The Consumer Sentiment Index, for its part, has been tracking attitudes lower since February, when it peaked at 110.4. The preliminary reading for August, released mid-month, was 104.5.

Expectations as reported by Reuters