Short Treasuries Post Huge Gains as Investors Go Liquid - TheStreet

Treasuries, the shortest-maturity issues in particular, rocketed higher on reports of escalating violence in the Middle East. The action dropped the five-year Treasury note's yield lower than the 10-year note's yield for the first time since January.

As the world's safest and most liquid asset,

Treasury securities typically rally in response to international strife, with the shortest-maturity issues, which are the most liquid, benefiting the most.

But while the rally was triggered by reports of retaliatory Israeli attacks on sites in the West Bank and Gaza, it continued thanks to the widespread selloff in the stock market, which broadened expectations of an economic slowdown and maybe even an interest-rate cut by the

Fed.

At the same time though, a spike in oil prices, also due to the friction in the Middle East, raised the specter of higher inflation across the board. That constrained longer-maturity Treasury prices.

The benchmark 10-year

Treasury note rose 12/32 to 100 6/32, dropping its yield 5.2 basis points to 5.724%. But the two-year note gained 6/32 to 100 9/32, slashing its yield 11.1 basis point to 5.836%, a new low for the year. And the five-year note soared 14/32 to 104 5/32, plunging its yield 11 basis points to 5.700%, also a new low for the year.

The 30-year

Treasury bond rose just 7/32 to 106 5/32, trimming its yield 1.6 basis points to 5.811%.

At the

Chicago Board of Trade

, the December

Treasury futures contract rose 10/32 to 99 16/32.

The headlines out of the Middle East ignited demand for short-maturity Treasuries immediately. But the subsequent sharp decline in stock prices added a dimension to the rally.

"People are looking at the Nasdaq and thinking that the wealth effect that was created on the upside could be reversed on the downside," said Tom Connor, head of government bond trading at

J.P. Morgan

. In other words, to the extent that rising stock prices helped drive economic growth by sustaining a high level of consumer confidence and consumer spending, eroding stock prices could destroy consumer confidence and curtail consumer spending.

Expectations of slower economic growth ahead were also reflected in the prices of

fed funds futures. As measured by the April contract, the odds that the Fed will lower the rate to 6.25% from 6.5% currently by the end of the first quarter rose to 68% from 52% on Wednesday.

Investors recognize that rising oil prices will make the Fed reluctant to cut rates because of the risk that inflation could accelerate,

Bear Stearns

Treasury market strategist Avram Altaras said. But to the extent that the Fed's perceived reluctance to cut interest rates pulls threads from the net under stock prices, it is benefiting the Treasury market anyway, he said.

Meanwhile, fear of rising inflation is keeping long-maturity Treasury yields from rallying as mightily as short-maturity yields have.

So is the idea that a slowing economy could consume the federal budget surpluses that are currently forecast, putting an end to the

buybacks that shrank the supply of long-maturity Treasuries, causing their prices to rise, J.P. Morgan's Connor said. "I think the surplus story is one shoe that's yet to drop," he said.

Economic Indicators

The weekly tally of

initial jobless claims

(

definition |

chart |

source

) rose to 306,000 from 301,000, as the four-week average fell to 301,500 from 306,500.

Separately,

import prices

(

definition |

chart |

source

) rose 1.5% in September, their largest gain in seven months, but oil prices were entirely responsible. Excluding oil, import prices fell 0.3%, their largest drop since March 1999.

Currency and Commodities

The dollar fell against the yen and rose against the euro. It lately was worth 107.56 yen, down from 107.78. The euro was worth $0.8626, down from $0.8656. For more on currencies, see

TSC's

Currencies column.

Crude oil for November delivery at the

New York Mercantile Exchange

rose to $36 a barrel -- the highest since Sept. 20, when it hit a 10-year high of $37.20 -- from $33.25.

The

Bridge Commodity Research Bureau Index

rose to 233.51 from 231.66.

Gold for December delivery at the

Comex

rose to $278.80 from $273.00.