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Unchanged CPI Causes Bond Market To Review the Situation

Bonds closed up but well off their session highs.

Like many recent bond rallies, this one looked better at the beginning than at the end. That's not to say it was all bad -- bonds rallied sharply today after the release of May's

Consumer Price Index

, and though the gains receded, by the end of the day the 30-year Treasury bond still rose 20/32 to trade at 88 27/32.

Due to the CPI, which was unchanged overall and up just 0.1% when excluding food and energy prices, the market isn't as panicked as it was previously. Believe it or don't, but prior to today the market was pricing in a 50-basis-point rate hike (or two quick 25-point ones). Now, it's moved away from that and back toward the opinion most share: that the

Federal Reserve

will raise the short-term lending target to 5% from 4.75% at the June 29-30 committee meeting.

The yield on the two-year note, which trades on expectations of monetary policy, fell 6 basis points to 5.58%, whereas the 30-year bond's yield fell 5 basis points to 6.07%. However, at one point the yield on the 30-year bond fell to 6.03%.

"This has not dissuaded anyone from the fact that the Fed is likely to move at the end of the month," said Ken Logan, managing analyst at

Thomson Global Markets

.

Traders used today's early rally as an opportunity to sell as the day wore on. The

Beige Book

, the Fed's anecdotal survey of economic conditions, provided a jot of encouragement, as reports from around the country said that wage pressures were building.

The yield on the two-year note has risen 44 basis points since May 13, as the market prepped itself for higher short-term lending rates, but the market reversed direction -- for one day, anyway. But that doesn't mean the market has turned optimistic yet, according to one futures dealer in New York, who said he had "not seen any genuine buyers in the short end of the market. Although the market is up, it's mostly short-covering."

"The general consensus is for a tightening of 25 points" in June, the trader added. In the fall, "it eased quickly three times in a row to support the world economy, and just left the rate there. It doesn't make any sense for the fed funds rate to be at this at post-crisis level."

The fed funds futures, a prime indicator of the market's thinking on future monetary policy, also reversed course and ended the day higher. The rate implied by the September fed funds contract traded on the

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Chicago Board of Trade fell 3 basis points today to yield 5.17%. This means the market believes the Fed will hike rates once, but is discounting a 68% chance of another hike by September, compared with an 80% chance yesterday.

Two analysts also said selling pressure was coming from dealers preparing to underwrite corporate issues. Dealers generally sell Treasury bonds ahead of bringing new corporate deals to the market to protect themselves -- if interest rates rise before they sell the new corporate deal, they can buy back the Treasuries to offset the higher cost of the corporate issue.

The Fed last cut interest rates in November of last year, the third of three 25-basis-point rate cuts undertaken as a response to the global economic crisis. Economists have speculated since as to when the Fed might take back one of those moves. Robust as demand was, inflation pressures did not materialize, and the Fed was reluctant to stifle growth without evidence of inflation.

April's 0.7% increase in overall CPI and 0.4% increase in the core rate put the market back on Fed watch. It also provoked a number of hawkish comments from several Fed officials worried about higher prices in conjunction with still-tight labor markets. The overall CPI was unchanged, provoking David Orr, chief capital markets economist at

First Union

, to comment that "May was a case of everything going right whereas in April everything went wrong." Today's report blunts the impact of last month's report, but not enough to avert at least one rate hike, Orr said.

This is because Fed officials of late have been more worried about the continued strength in consumer demand in the retail and housing sectors in recent weeks. The seasonally adjusted rate of

housing starts

rose 6% to 1.676 million in May, up from 1.576 million in April, the

Commerce Department

reported today.

Today's Beige Book highlighted those pressures, saying: "Labor markets remain very tight in almost all districts, with increased reports of upward pressure on wages in many parts of the country." The various districts report strong consumer spending and very tight labor markets, even though "many districts report pockets of higher prices for some specific sectors and goods."

Fed Chairman

Alan Greenspan

addresses the

Joint Economic Committee

tomorrow. But unless the notoriously even-handed Greenspan indicates that the Fed will not raise rates (or plans to go rate-hike crazy), the market's mind seems to be well made up -- for now.