PPI, Europe Make for a Happy Bond Market

Treasuries are building on their gains, but they've come off their best levels.
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Treasury bonds are extending yesterday's gains on the back of this morning's favorable

Producer Price Index

report and the overnight rallies in European bond markets. But stocks have risen off their lows, and that's eroding some of the Treasury market's gain.

Lately the 30-year Treasury bond was up 3/32 to trade at 97 7/32. The yield fell to 5.44%. And believe it or don't, volume isn't too shabby. As of 10 a.m. EDT tracker

GovPX

reported volume down 21% when compared with the average second-quarter Friday.

This morning's March PPI report showed only a 0.2% gain for the overall index. This figure includes food and energy prices, and was forecast to rise 0.3% due to March's spike in crude oil prices.

"It looks like the biggest gains in oil came too late for the survey and there should be an even bigger pop in prices in the April report," said a comment by economist Joel Naroff of

Naroff Economic Advisors

. "About the only issue is that there has been a slow but steady rise in the year-over-year index. Ultimately, that should put some pressure on prices, though the meagerness of the gains does not portend any sharp rise in inflation anytime soon."

The core PPI, which excludes energy and food prices, was unchanged, as forecast. In addition, European bond markets, which closed before the

European Central Bank

cut interest rates by 50 basis points to 2.5%, got their first chance to rally on that news this morning. Germany's 10-year bond fell 8 basis points to yield 3.83% and the 10-year British bond fell 7 basis points to 4.37%. Mild weakness in U.S. stocks has also contributed to the strength in U.S. bonds.

"European bonds rallied overnight, and that gave us a good tone going this morning," said Bill Hornbarger, fixed-income strategist at

A.G. Edwards

. "And oil will certainly impact the inflation data but other things are not too troubling. It plays into inflation a little bit, but not to the degree where it's troubling the market."

There's been reports that the recent rally will cause mortgage-backed investors to begin buying Treasury bonds en masse, similar to what they had to do last year when the Treasury market ran wild. Holders of mortgage securities, which are bundled groups of mortgages sold as bonds, have to guard against prepayments. When rates fall, it's likely that prepayments will occur, which essentially converts those securities to cash and causes the overall duration of such an investor's portfolio to shorten vs. the aggregate index. In other words, they'll underperform.

To protect against this risk, those investors buy Treasury securities when bonds rally. The talk was that 5% on the 10-year bond was considered significant and would bring those investors into the market.

"I don't think 5% holds any magic, but any move down in rates shortens your duration a bit," said Gary Pzegeo, portfolio manager at

Evergreen Keystone

in Boston. "But they haven't shortened as much as they extended. From October to March 4, the drop in the bond contract was about 15 points. From March 4 to today, we've had roughly a 4-point pick-up."

The yield on the 30-year bond, conversely, rose about 100 basis points; since then it's rallied about 30 points.