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The Treasury market ended the day roughly where it stood before the


afternoon decision to hike the

fed funds rate

from 5.5% to 5.75%.

The long end of the market -- the 30-year bond -- ended up sharply in response to this morning's unexpected announcement that the Treasury Department will issue fewer 30-year bonds in the future. In the middle of the market, the 10-year note rode the long bond's coattails a bit higher. The five- and two-year notes were mixed.

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In all, the day's action advanced the process that has been underway for three weeks now: Longer-term debt securities are outperforming shorter-term ones, driving most longer-term yields lower than most shorter-term yields. Normally, the yields on longer-term obligations are higher, to compensate investors for the increased price risk associated with tying up money for long periods of time.

A combination of strong economic growth, which has the Fed in rate-hiking mode, and a flush Treasury, which is cutting back on debt issuance, especially at the long end, has pulled the rug out from under the normal paradigm. Rate hikes by the Fed tend to lift short-term yields, while reduced supply of long-term bonds gives them a scarcity value that drives prices up and yields down. The same combination of forces has inverted England's yield curve for the better part of the last few years.

"I don't know where exactly the split is, but we've got two Treasury markets,"

Thomson Global Markets

managing analyst Ken Logan said. "One is focusing on the Fed, and one is focusing on the Treasury."

"The Treasury is the more influential force by far," Logan continued. "It's as if it's pulling the plug from the tub, and people are saying, 'We've got to grab as far out the curve as we can.'" The market, he said, "is making a massive adjustment. We're in a price discovery process: Where should things be priced on the curve?" For now, he said, the trade of choice is the one that will profit from further inversion of the yield curve -- short the short end, long the long end.

The 30-year Treasury bond ended up 1 28/32 at 97 28/32, dropping its yield 14.5 basis points to 6.284%, a level it hasn't seen since mid-December. The 10-year note gained 11/32, its yield sinking to 6.571%. The five-year note gained 3/32, its yield 6.654%. And the two-year note fell 1/32, its yield 6.596%. "There's almost a panic to get long paper,"

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Bear Stearns

Treasury market strategist Avram Altaras said in the hours after the auction announcement.

At the

Chicago Board of Trade

, the March

Treasury futures contract finished up 19/32 at 93 15/32.

The massive outperformance of the bond has extended the inversion of the Treasury yield curve to new extremes. The long bond's yield dropped 31.2 basis points below the two-year note's (from 15 yesterday), 37 below the five-year note's and 28.7 below the 10-year note's. The curve from the two-year note to the 30-year bond hasn't seen that degree of inversion since 1989.

Bond guru

Bill Gross

argues in an essay posted on his firm's

Web site today that the 30-year Treasury bond yield has peaked

intermediate-maturity yields "are another story", and that the inversion of the Treasury yield curve that has occurred in the last few weeks could last for years.

Fed Delivers, Treasury Surprises

The decision by the Fed's monetary policy panel, the

Federal Open Market Committee

, to hike the fed funds rate to 5.75% was expected by pretty much everyone. The only people who didn't expect a 25 basis-point hike expected a 50 basis-point hike.

The FOMC's

statement announcing the rate hike also fell in line with expectations. Under a

disclosure policy announced Jan. 19, FOMC statements, starting with today's, will indicate whether the risks to its twin goals of price stability and sustainable economic growth are weighted mainly toward higher inflation, weighted mainly toward economic weakness, or balanced. (Gone is the FOMC's "bias" with respect to the fed funds rate. In past announcements, it indicated that it was biased either to tighten or ease monetary policy in the near future, or that it was neutral.) As expected, the statement says the committee believes "the risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future."

That left the Treasury market in the position it assumed after the

Treasury Department's


announcement of the details of the quarterly refunding -- its auction of long-dated notes and bonds.

At a press conference in Washington, the Treasury Department announced that next week's auctions will be sized as follows: $12 billion five-year notes (4 3/4-year, actually -- they're going to reopen, or add to, the five-year note issued in November), $10 billion 10-year notes and $10 billion 30-year bonds (30 1/4-year, actually -- the Treasury hasn't issued a long bond due in May since 1991). The expected amounts, according to

Wrightson Associates

, were $15 billion five-year notes, $12 billion 10-year notes and $10 billion 30-year bonds. The auctions will take place next Tuesday, Wednesday and Thursday.

The surprise in the announcement was that the other 30-year bond auction, in August, will become a reopening of the February bond issue, and that it will be "significantly smaller" than the February issue. Similarly, two of the four annual five- and 10-year note auctions will become reopenings of previous auctions, and the reopenings will be "smaller" than the new issues.

In addition, the Treasury announced that its buyback program will start within two months, focus on issues that mature in more than 10 years, and amount to about $1 billion apiece. The buybacks are a debt reduction measure made possible by the federal budget surplus. They are an alternative to further reducing the auction schedule, which impairs market liquidity.

Gross' Thesis

In his essay published today, bond guru Gross argues that two forces will keep the Treasury yield curve inverted -- unless the stock market crashes. The first, which is well-understood, is the Treasury Department's planned buyback program. Because federal budget surpluses have reduced its need to borrow, the Treasury is planning to buy back $30 billion of its securities from investors this year alone.

Buybacks will shrink the supply of long-dated Treasuries, while demand for long-dated assets from investors who need them remains constant. That drives the price of long Treasuries higher and their yields lower.

The second force, Gross says, is the fact that Fed Chairman

Alan Greenspan

, by cutting interest rates aggressively after the stock market crash of 1987, and in response to the market turmoil of the fall of 1998, "has demonstrated to investors that he will, when required, lower interest rates and provide emerging liquidity to support the stock market." This amounts to a free put option for stock investors, Gross says. Accordingly, stock prices will be higher than they should be at any given point in time, the economy will be stronger than it should be and the short-term interest rates controlled by the Fed will be higher than they would otherwise be. As long as the Treasury is buying back long-dated paper, only a stock market crash that prompts the Fed to cut short-term interest rates has the power to un-invert the yield curve, Gross says.

Economic Indicators

There were no first-tier economic indicators today. This week's highlight, the January

employment report

, comes out at 8:30 a.m. EST Friday.

Today, the weekly

Mortgage Applications Survey

detected a drop in refinancing activity and a pickup in new mortgage activity. The Refinancing Index fell to 384.4 from 413.6, while the Purchase Index rose to 292.6 from 286.1.

New home sales

accelerated more than expected in December, to 900,000 from a revised 861,000 in November.

And the

leading economic indicators

index rose 0.4% in December, a tenth more than expected.

Currency and Commodities

The dollar rose strongly against the yen and fell a bit against the euro. It was lately worth 108.14 yen, a level it hasn't seen since September, up from 107.81 yesterday. The euro was worth $0.9761, up from $0.9721 yesterday.

Crude oil for April delivery at the

New York Mercantile Exchange

fell to $27.55 a barrel from $28.22 yesterday.


Bridge Commodity Research Bureau Index

was unchanged at 209.65.

Gold for February delivery at the


rose to $287.7 an ounce from $285.4 yesterday.