Treasuries Caught in a Rundown

Core CPI vs. rising oil prices and conflicting Fedspeak leaves bonds unchanged, but the yield curve inverts.
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Updated from 10:13 a.m. EST

The bond market finished Wednesday flat amid the ongoing tug-of-war between inflationary data and signs of an economic slowdown.

The benchmark 10-year settled at 101 9/32 to yield 4.33%, little changed from late Tuesday. The yield fell as low as 4.29% in morning trading, the lowest since Sept. 30, and ran up as high as 4.36% intraday.

The 30-year bond stood at 112 28/32 to yield 4.51%, also little changed on the day. The five-year also ended the day flat, yielding 4.27%. Bond prices and yields move in opposite directions.

The two-year note also ended the day flat to yield 4.33%, while the three-month Treasury bill ended the session yielding 4.35% vs. in a typical curve, in which the yield of longer-dated maturities are higher than the shorter-dated ones. This so-called inversion in the yield curve has historically signaled 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 Miller Tabak. "Once the inversion rises to the midteens

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

In economic releases, overall consumer prices fell by 0.1% in December, the Labor Department reported, vs. expectations for a 0.2% rise. Core consumer prices, which exclude food and energy costs, posted a 0.2% gain for the month, in line with analyst estimates.

But the report also showed that consumer prices rose by 3.4% for the year, the largest jump in five years, due to surging energy costs. And the core rate for the year came in at 2.2%, unchanged from 2004.

"I think the market is really concerned with the core. ... It wants to see that higher energy prices aren't filtering down to the consumer level," said John Derrick, director of research at US Global Investors. "Bonds have rallied for the last six weeks or couple of months on expectations that core inflation will remain muted or contained, and this didn't change things that much as far as expectations go."

A morning report from the Treasury showed that net foreign purchases of U.S. assets came in at $89.1 billion in November, down from $104.2 billion in October, still a record but down from the originally reported $106.8 billion.

"Overall, the data were plain vanilla, with no apparent trend changes in the pace of buying in the major asset categories," according to Miller Tabak. "That said, it will be comforting to some to see that both China and Japan were net buyers of Treasuries during November following net sales in October."

But the market also warily eyed rising crude prices as oil prices remained near the strongest levels seen since late September. The question, once again, is whether energy costs would drag the economy down or create inflationary pricing pressures.

Mixed messages from the

Federal Reserve

sent similarly mixed messages to investors, with Richmond Fed President Jeffrey Lacker saying that the outlook for the economy this year is "fairly encouraging," in a bid to dispel fears that the economy is slowing too fast.

"Employment is expanding again at a healthy pace, consumer spending continues to grow briskly, and business investment spending is robust," he said. The comments from Lacker, who is a voting member of the Federal Open Market Committee, somewhat dampened hopes that the Fed will end its rate-hike campaign.

The central bank raised the fed funds rate by a quarter-point 13 straight times since June 2004, bringing the rate to 4.25%.

On the other side of the fence, Fed Governor Susan Schmidt Bies said policymakers need to be vigilant about keeping inflation in check, but told reporters after her speech that the Fed is "much closer to our end point," on rate hikes.

The Fed's beige book of economic activity showed that labor markets have "tightened" in some districts, but that wage gains remain moderate. Philadelphia, New York, Boston and Minneapolis also noted significant price increases in energy-related costs, and some manufacturers said they will hike prices to cover these additional expenses.

Derrick said that the day's price data confirmed market expectations that the Fed will raise the overnight lending rate by a quarter-point at the end of January, with maybe just one more interest rate hike in March.

In auction action, the Treasury sold $8 billion in four-week bills.

Fannie Mae

(FNM)

sold $2 billion worth of three-month bills and $1 billion in six-month bills.