Stock Woes Boost Bonds

Equities' weakness helps Treasuries past early hesitation.
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Updated from 12:09 p.m. EST

A stock market meltdown pushed Treasuries back into positive territory Friday, with yield curve between 10-year and two-year notes flat, after spending most of the day inverted.

A volatile week ended with the

Dow Jones Industrial Average

and the

S&P 500

posting their sharpest single-day point drops since March 2003. It was also the Nasdaq's worst fall since September 2003.

Investors made a flight to safety into the Treasury market after high oil prices, disappointing earnings and geopolitical tension made people wary of holding stocks going into the weekend.

" Yes,

Citigroup

(C) - Get Report

,

General Electric

(GE) - Get Report

and

Motorola

(MOT)

disappointed... but something happened that worried investors about health of the economy," says Hugh Johnson, chairman of Johnson Illington Advisors. "And that was rising oil prices."

February crude rose $1.52 to $68.35 a barrel, and has risen more than 12% in 2006 on rising political tensions in Nigeria and Iran. Johnson said the rise in oil prices is far more comprehensive and meaningful than current earnings results because it could mean that forecasts for the economy and for 2006 profits may be too high.

"The biggest risk in 2006 is that the

Federal Reserve

will be seduced by worries about high inflation, raise interest rates too high and slow economic growth. Rising oil prices play into this," Johnson said.

The benchmark 10-year note settled up 5/32 of a point to yield 4.35%, after hovering near breakeven for most of the day, down from 4.38% in the previous session. Bond prices and yields move in opposite directions.

The two-year note added 1/32 to yield 4.35%; while the three-month, which is most sensitive to changes in the fed funds overnight lending rate, added 3/32 of a point to yield 4.35%. The two-year and three-month yields briefly rose higher than that on the 10-year in morning trading.

The 30-year bond was up 12/32 to yield 4.52% and the five-year was up 3/32 to yield 4.29%.

Yields on longer-dated Treasuries are usually higher than on shorter-dated ones to compensate investors for the additional risk of lending money for a longer period of time.

An inversion between the two ends of the curve can mean that investors see more risk in the near term and want to be compensated accordingly. This has historically preceded an economic slowdown or recession, particularly an inversion of the spread between 10-year and three-month Treasuries.

"This is the yield spread the

Fed

is most concerned with," according to a research note from brokerage Miller Tabak. "Once the inversion rises to the midteens

in terms of basis points, odds of a recession within four quarters jumps to 30%."

But David Ader, chief bond strategist at RBS Greenwich Capital, says that the most recent inversion and the one that occurred at the very end of 2005 are more indicative of the "tremendous amount of uncertainty" in the market vs. an economic harbinger.

"We're moving sideways," says Ader. "The new reality is that the Federal Reserve is in neutral, and neutral can mean that they don't have to hike in March, but they might, because they can now be data dependent."

The data out this week have been mixed, signaling both robust gains in employment and falling producer and consumer prices, which have kept the market grinding in a narrow range all week. Friday's consumer confidence reading was no different.

The stronger-than-expected report from the University of Michigan knocked Treasuries off their highs and unwound the inversion between the 10-year and three-month yields, with the preliminary reading on January consumer sentiment up 2.1% to 93.4 vs. expectations for a slight uptick to 92.5. Both the current conditions and outlook components made gains.

This marked the index's third straight monthly rise, nearly matching a three-month decline that occurred after hurricanes hit the Gulf Coast and energy prices spiked; still, the reading stands 10% lower year-on-year.

The report showed that confidence rose due in part to falling unemployment. Tightening labor markets are a closely watched indicator of inflationary pressures in the economy, and could signal to the Fed that more rate hikes are necessary to take some heat off of the economy.

Adding to speculation that the central bank may have at least two rate hikes up its sleeve were comments made by Richmond Fed President Jeffrey Lacker, who said, "I don't think that we're done

raising rates yet."

A voting member of the Federal Open Market Committee, Lacker seemed optimistic that inflation is under control. But following a Friday morning breakfast sponsored by the Risk Management Association, he also told

Reuters

that the central bank would be vigilant about keeping inflation in check.

"I don't think the risk is entirely past, yet that core (inflation) may drift up ... I wouldn't want it to be more than moderate and transitory," Lacker was quoted as saying.

Looking ahead, "the uncertainty will probably get worse because we have a large number of economic, geopolitical and pure political issues that can come to the fore between now and March, which is the meeting that no one is sure about," says Lehman Brothers' Drew Matus, the firm's senior U.S. economist, with a specialty in fixed-income investments.

In addition to the normal flow of economic data between now and the Fed's March meeting, the FOMC will also release its statement and minutes from the Jan. 31 meeting, and the market will have to adjust to a new Fed chief as Greenspan steps down and Ben Bernanke likely takes the reigns.

"Everyone expects Bernanke to get confirmed, but the vote is scheduled for the same day that Greenspan is set to retire," Matus says. "Any delay in the confirmation process will not be appreciated by foreign investors."

Foreign investors have been buying up 10-year notes at a rapid rate. The Fed reported Friday that foreign holdings of Treasuries and agency debt rose by $1.81 billion in the past week and total holdings as of yesterday amounted to $1.536 trillion.

Plus, there's the return of the 30-year bond to contend with, which some Treasury watchers are not sure will go well.

Matus says it's a risky auction because it will be difficult to estimate where to bid on the bond. Typically, he says, bidders look to the last month's auction, estimate what the extra month is worth in terms of yield, and make a bid.

But with the 30-year, there's a five-year void and bidders will have to figure out what that gap is worth. "The larger the number of opinions the greater potential for a big spread," said Matus. "A lot of players may buy after the auction because they'll wait to see how the uncertainty pans out."

The 30-year bond is part of a slew of Treasury auctions over the next few weeks that includes two-, three- and 10-year notes;

Briefing.com

estimates that the total debt on offer will amount to $100 billion.

Those technical factors could weigh on the Treasury market, on top of a sea of corporate offerings slated for the coming weeks.

Freddie Mac

(FRE)

said it will hold a $6.5 billion, three-part auction next week, with $2 billion in one-month and $3 billion in three-month bills offered on Monday and $1.5 billion in six-month bills on Tuesday.

The corporate debt market saw $8.8 billion in new issues in this shortened trading week, after seeing a record $37.9 billion issuance the week before.