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Treasury Yields Drift Lower, Bucking Trend

The budget surplus continues to grow, further improving the supply outlook. Unfortunately, supply's only part of the story.

Treasury prices are higher again today but on very light volume as traders count down to the first of three big events of the week, the


announcement Wednesday afternoon of any change in monetary policy.

With no market-moving economic indicators on the calendar and trading volume running at 80% of normal for a second-quarter Monday at 10 a.m. EDT according to tracker


, the benchmark 30-year Treasury bond lately was 17/32 higher at 88 9/32, trimming its yield 4 basis points to 6.11%. Shorter-maturity note yields were outperforming the bond. The two-year note's yield, for example, shed 5 basis points to 5.70%.

The news this morning that the federal budget surplus for fiscal 1999 is likely to be significantly larger than previously forecast -- the latest forecast reported in today's

New York Times

and announced by

President Clinton

this morning is for a $99 billion surplus, up from an earlier estimate of $79 billion -- certainly provides a positive backdrop for the day's action. A surplus means the nation can pay down its debt by issuing fewer new bonds than it has bonds maturing. The shrinking supply supports Treasury prices.

But the revised forecast can't take credit for the market's move, says Tony Crescenzi, chief bond market strategist at

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Miller Tabak Hirsch

, noting that improving budget forecasts have been par for the course for some time. In addition, with a presidential election looming, the country may be on the verge of a massive change in the political landscape that could completely alter the budget outlook.

Finally, while contracting supply is indisputably better for the bond market than expanding supply, "in the end it's all about how much inflation we have and how much the Fed tightens," Crescenzi said. Case in point: the current quarter, when the Treasury's largest-ever $120 billion debt paydown has coincided with a more-than-50-basis-point rise in most Treasury yields.

In his view, today's price action represents little more than a reprieve from last week's almost relentlessly negative sentiment, which on Thursday pushed the long bond's yield to its highest level in over a year and a half.

In the larger scheme of things, today's action is little more than prologue to what will start on Wednesday with the Fed's announcement, and continue on Thursday and Friday with two key economic reports -- the

Purchasing Managers' Index

and the

employment report

, both for June. The three events will become the new basis for predicting whether and how the Fed will change monetary policy in the months ahead.

Bill Hornbarger, fixed-income strategist at

A.G. Edwards

in St. Louis, said the likeliest outcome of the Fed meeting is a hike in the fed funds rate to 5% from 4.75% (which virtually everyone expects), accompanied by an indication that the Fed is retaining its official bias in favor of raising the rate. That being the case, the market will likely rally if the Fed announces a shift to a neutral bias, and tank on the off chance the Fed hikes rates more than 25 basis points, Hornbarger predicted.