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Treasuries' Glow Fades Further

An ugly week in Treasuries finished up on an ugly note, as dealers struggled to get investors to buy some of the $38 billion of new issues the government let loose this week.

The benchmark 30-year bond -- the new one issued yesterday -- finished the day down 1 3/32 at 98 1/32, its yield rising to 5.38%. That's the highest yield on the active long bond since Aug. 25.

But that's not the half of it. Over the last six trading sessions, going back to last Thursday, Oct. 29, the old 30-year bond, the one issued back in August, tacked on 35 basis points of yield, from 5.08% to 5.43%. Over the same period, the two-year Treasury note saw its yield rise from an even 4% last Thursday to 4.62% today.

Expectations as reported by


"We've gone from being where Treasuries were ridiculously overvalued relative to other markets and the fed funds rate, to a situation where they're fairly valued -- not cheap, but fairly valued -- in a week!" said Jim Kochan, senior bond market strategist at

Robert W. Baird

in Milwaukee.

There are three main reasons for the market's dismal performance over the last week.

The first is simply supply. The Treasury conducted its quarterly refunding this week, selling $16 billion of new five-year notes, $12 billion of new 10-year notes and $10 billion of new 30-year bonds. Even though the size of these auctions has been contracting as the federal budget deficit has closed, the Treasury market never likes them. Prices almost always fall around refunding time as dealers work to place the new issues with investors.

This time was worse than usual, however. That's partly because Treasury yields, in spite of having risen this week, remain quite low by historical standards. It was only a month ago that the long Treasury bond touched its all-time low yield of 4.71%. At the same time, because riskier bonds like corporates, asset-backeds and mortgage-backeds got dumped in the massive flight to quality that lifted Treasuries to that height, they're quite cheap now, making them far more attractive than Treasuries on a relative basis.

The refunding was worse than usual also because a few key segments of the buying community -- hedge funds, overseas accounts and dealers -- are either wholly or largely out of the game, Kochan said. "The market has lost some of its most aggressive sponsors."

The second factor in the Treasury market's poor showing this week was some slippage in the odds that the


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will cut the fed funds rate from 5% when it meets on Nov. 17. Before this week, most market analysts were saying that a third rate cut (the Fed cut rates on Sept. 29 and again on Oct. 15) was a sure thing.

But as the prices of stocks and, more importantly, risky bonds continued to recover this week, and Fed Chairman

Alan Greenspan

noted in a

speech on Thursday noted "significant signs of some reversals" in the credit markets, analysts downgraded the odds of a near-term rate cut. The recent rate cuts, most believe, were aimed chiefly at reviving demand for corporate bonds in order to avert a credit crunch. Direct stimulation of the economy -- which by most measures remains quite healthy, if somewhat less vibrant than it was earlier in the year -- was secondary.

Most still believe that the Fed will cut rates again as economic growth continues to slow. They're just not so sure it will be this month.

Finally, the crazed-with-fear buying which lifted Treasuries to their best levels last month continued to reverse this week, as investors put money back into stocks domestic and foreign, and into other types of bonds.

"We topped out on Oct. 7 because the whole world was afraid that every place but the U.S. was imploding" -- Russia, Japan and Brazil in particular, said John Canavan, Treasury market strategist at

Stone & McCarthy Research Associates

in Princeton, N.J.

Things are far from hunky-dory in those corners, but at least they're better than they were, Canavan points out. The ruble has stabilized, Japan has passed banking reform legislation and Brazil is securing international financial assistance that should keep it from having to devalue the real. In short, the rest of the world is looking a bit more hospitable to investors.

Where do we go from here? It depends on how much the economy slows, and how quickly, and on how the Fed responds. The prevailing view seems to be that as growth continues to slow -- but not to the point of recession -- over the next six months, the Fed will drop the fed funds rate once or twice more, to either 4.5% or 4.75%, and that Treasuries at current levels are fairly valued to slightly cheap.

"Until we digest the supply it's going to be tough to find much upside," Canvan said. "But once we do, we're still looking at little or no inflation, the potential for more Fed easing, slowing growth and supply won't be an issue again until early next year." Against that backdrop, yields should at least stabilize at current levels, and possibly improve somewhat, he said.

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