Relief of Inflation Fears Trims Treasury Yields

But short-covering by traders who can't quite believe the numbers was partly responsible.
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The bond market rallied again today, dropping yields to their lowest levels in three weeks.

A better-than-expected report on wholesale inflation sparked the rally, and a big drop in oil prices supported it. But market participants said the rally was partly attributable to short-covering by traders who had expected bad news on the inflation front.

The

Producer Price Index, which measures wholesale inflation, advanced 0.2% in November, in line with expectations. But the core PPI, which excludes volatile food and energy prices, was unchanged. Economists polled by

Reuters

had forecast a 0.1% gain on average.

The benchmark 30-year Treasury bond leapt 21/32 to 99 13/32, trimming its yield 5 basis points to 6.17%, the lowest it's closed since Nov. 19. Shorter-maturity note yields shed 3 to 6 basis points.

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"We had a little relief trade," said Matt Frymier, a note trader at

Banc of America Securities

in San Francisco. "Most traders are in disbelief of the economic numbers. We keep waiting for the truth."

"The malls are packed with people, and everything seems expensive -- gas seems expensive, homes seem expensive," the trader continued. "You see these things, and it certainly scares you from being long. Guys, if anything, set up a little short for the inflation numbers, thinking the truth is finally going to come out."

On its own, the PPI shouldn't inspire such euphoria in the bond market, analysts say, because in its efforts to determine the appropriate level for the

fed funds rate, the

Fed has made it clear it's taking its cues primarily from the tightness of the labor market.

Also,

Merrill Lynch

Treasury market strategist Jerry Lucas observed: "Good inflation news by itself is not going to keep the Fed from tightening, but bad inflation will."

But bonds also got a boost today from a 3.8% drop in the price of oil. It fell after the

U.N. Security Council

approved a six-month extension in Iraq's oil-for-food program. Crude for January delivery dropped to $25.20 from $26.15 a barrel on the

New York Mercantile Exchange

and traded below $25 on an intraday basis for the first time since Dec. 2.

Even as they live in fear of inflation heating up, bond market participants are sanguine about the market's near-term prospects. The Treasury market is wont to rally in the final weeks of the year as investors reach for the safety and liquidity of government bonds to pretty-up their balance sheets, and that dynamic is even stronger this year because of the Y2K date change. "Y2K does impart a bullish bias," Lucas said.

For most of the year, Frymier added, "people have been willing to be short, because that's what's paid off. But at year-end, with the need for window-dressing, they can't really be short. I'm constructive on the market because of

these cash-flow considerations."

Beyond the

Consumer Price Index on Tuesday, the bond market's chief preoccupation for the balance of the year is whether the Fed will retain its neutral policy stance on interest rates. A switch to a tightening bias would increase the chances of another fed funds hike at its first meeting of the new year on Feb. 1-2. "Sometimes the market reacts more

to a bias shift than to an actual tightening," Lucas pointed out.