Treasuries Start Well but Sputter in Afternoon

After building up a good head of steam this morning, Treasuries end the day little changed.
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The surprising 30 basis-point rally that began last Wednesday might have petered out this afternoon.

Treasuries were higher again this morning, following a favorable refunding announcement from the

Treasury Department

. But the early burst of energy, which pushed the 30-year bond's yield to its best level since Oct. 4, couldn't be sustained and Treasuries ended the day virtually unchanged.

With the important October

employment report

due out Friday, and the Treasury's $25 billion quarterly refunding next week, a bond yield of 6.12% is no longer as attractive to investors as 6.40% was last week.

"We've had a three-point rally off the lows. There's no reason to extend it until Friday's numbers," said Larry Berman, market strategist at

CIBC World Markets

in Toronto.

Now, about that quarterly refunding, the catalyst for this morning's rally. The Treasury Department announced it would sell $25 billion in its auctions of five- and 10-year notes next Tuesday, less than the market's expectation for $27 billion. That's bullish -- diminished supply means more money is chasing fewer securities, which will drive prices higher and yields lower.

Another positive for the market: instead of selling a new 10-year issue, the Treasury will auction more of the August 10-year note, referred to as reopening an existing issue. This increases the number of existing new, or on-the-run, Treasury bonds, which enhances liquidity.

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At one point, the 30-year Treasury bond was up 13/32. Lately, it was up just 3/32 to 99 26/32, dropping the yield 1 basis point to 6.13%.

"We have made higher highs the last couple of days, which is a positive, but since we can't hold those gains, it's offsetting," Berman said.

Technical factors were important in jumpstarting last week's rally. But some now think the Treasury market is believing too much of the good news. Jim Kochan, Treasury market strategist at

Robert W. Baird

, believes the market is setting itself up for trouble should the employment report blow out expectations. (The current consensus forecast is for a 313,000 increase in

nonfarm payrolls

, according to


, although a few predict 400,000 to 500,000 is a possibility.)

"There's a significant risk that the numbers are going to be very strong -- stronger than expected -- and people are going to have to rethink their forecasts on interest rates," Kochan said. "We were priced at levels consistent with a 5.5% funds rate and that's not true anymore, and that bothers me."

The market's expectations for a


rate hike at the Nov. 16 meeting have indeed declined dramatically. The fed funds futures contract listed on the

Chicago Board of Trade

was lately pricing in a 47% probability of a Fed rate hike, from 5.25% to 5.5%.

That's the first time since Sept. 24 that the November futures has priced in less than a 50% chance of a rate increase. Last Thursday, the fed funds contract was pricing in a 73% chance of a hike.

The market's diminished expectations for a hike can be linked to Fed Chairman

Alan Greenspan's

bullish sounding speech last Thursday, when he expressed confidence that improved productivity will continue to benefit the U.S. economy. Several economic releases have displayed a mild slowing in growth, such as this week's

new homes sales

release and October auto sales, which were weaker than expected.

"The timing of these things is causing some doubt," said Peter Kretzmer, senior economist at

Bank of America

, who believes the Fed should -- and will -- raise rates come Nov. 16. "It's the data, yes, but it's the data on top of what appears to be a reluctance anyway on the part of Greenspan."

The Federal Reserve's

Beige Book

, an anecdotal account of nationwide economic conditions, was mixed. It reported that some slowing in economic growth is taking place. But the survey also said "many districts report a pickup in wage increases, but overall prices remain stable with some notable exceptions: Increases in prices were noted for some manufacturing inputs, health care, memory chips and construction materials."

Berman thinks the Nov. 16 rate hike is a no-brainer.

"It's a gimme that they're going to raise rates," he said. "I don't care what the number is Friday. There's enough anecdotal evidence of

inflation pressures. If they don't go now, and then start seeing price pressures, then the market will punish them."