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Treasuries Slump on TIC Data, Beige Book

Foreign purchases exceed expectations but fail to fund the trade deficit.

Updated from 12:21 p.m. EST

Treasuries got hammered Wednesday, erasing the previous session's gains, hit by the net foreign holdings report and robust economic readings.

The benchmark 10-year ended the day down 10/32 to yield 4.73%, while the 30-year bond plunged 25/32 to yield 4.75%. Bond prices and yields move in opposite directions.

The two-year note edged lower by 2/32 to yield 4.67%, and the five-year lost 3/32 to yield 4.69%.

All eyes now turn to the much-anticipated CPI report for February, which is expected to show a 0.2% gain, as well as readings on the housing market, weekly jobless claims and the Philadelphia Fed manufacturing index.

"Concerns over the availability of excess capacity in the economy and the uncertainty surrounding potential growth complement the monetary policy issues supporting our call for the FOMC to maintain a bias towards tightening even after a 5% nominal funds rate has been established," says Steve Ricchiuto, chief U.S. economist at ABN Amro.

Fed officials will speak about the economy after the market's close, including comments from Atlanta Fed president Jack Guynn and San Francisco's Janet Yellen. Both are voting members this year on the policy-setting

Federal Open Market Committee


In new corporate issues,

Deutsche Telekom

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said it will sell about $2.5 billion in notes and


(XRX) - Get Xerox Holdings Corporation Report

also said it will sell debt, but gave no details.

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The Federal Reserve's "beige book" survey of economic conditions said that economic activity increased across the country in January and February, with businesses still feeling cost pressures. Higher energy costs were frequently mentioned, the Fed said.

According to the report, employment increased in most regions and over several sectors. And almost every bank district reported shortages of high-skilled workers, which resulted in more rapid pay raises for those workers. This fact could help justify fears that the economy is nearing maximum employment, or the lowest level of unemployment possible before wage inflation kicks in.

But retail prices rose at only a moderate rate, the report said, and labor cost pressures were little changed, with most districts saying wages increased modestly on average.

Prior to the beige book release, Treasuries had already lost ground on news that foreign investors boosted their net holdings of U.S. assets by $66.0 billion in January, but more money went into stocks than into bonds.

The net holdings number reported by the Treasury Department exceeded expectations, but it wasn't enough to cover the $68.5 billion trade gap posted in the same month.

And private foreign investors sold $4 billion in Treasuries in January after buying fewer U.S. government securities in December. The news sank the Treasury market, which had rallied during the previous session on weaker-than-expected retail sales data.

The Treasury was expected to report that international capital inflows rose to $65 billion, according to Lehman Brothers estimates, but December's inflows of Treasury notes, corporate bonds, stocks and other financial assets were downwardly revised to $53.8 billion from $56 billion.

"Some people look at the long-term inflows account as sort of a core stable source of financing," says Jim Glassman, chief economist at JPMorgan. "But when you've already seen what happened to the dollar, you probably know how the

Treasury data will turn out. If the dollar is stable or moving up, investors were probably happy to recycle money back into the U.S. economy."

Dropping Treasuries

Net foreign purchases of long-term domestic securities hit $78.0 billion, with foreign official institutions accounting for $20.2 billion of that amount and private investors accounting for $57.9 billion, the Treasury said.

Japan, the largest holder of Treasury notes, held $668.3 billion in January, down from $684.9 billion in December. Meanwhile, Chinese investors held $262.6 billion in January, vs. $256.7 billion in December.

Glassman says the strength in equities and relative weakness in Treasuries makes sense because U.S. central bankers are in the midst of adjusting the nation's monetary policy.

"It's not a natural thing to want to be buying fixed income in that kind of environment," he says. "And news that the economy is stronger and that it's prompting the

Federal Reserve

to raise rates may not be the only factor drawing money to the dollar. It could also just be the perception that the economy is strong, and that will put money into the equity market.

U.S. investors also bought fewer foreign-issued securities in January, purchasing $12.0 billion in foreign stocks and bonds, down from $20.8 billion in December.

The market has long been concerned about when foreign support in Treasuries would diminish, says John Shin, senior economist at Lehman Brothers.

The "conundrum" of low long-term yields despite 14 straight hikes to the overnight lending rate has been tied to demand from pension funds and foreign investors.

Robust overseas demand has led former Fed chief Alan Greenspan and new Chairman Ben Bernanke to conclude that high short-term and low long-term yields do not signal an economic slowdown, even though the phenomenon has often been a leading indicator of recessions. (

Click here for more on the inverted yield curve.)

"I think there's still a significant natural market for Treasuries, even though there has been concern about Asian central banks pulling out or lightening up on buying," says Shin, noting that these concerns have been exacerbated by news that Japan is ending its ultra-easy monetary policy.

"There has been a relatively stronger economic outlook," he says. "A lot of what you've seen in the Treasury market has been repricing to account for that economic outlook. Our view is that the fed funds rate will hit 5.5% by the end of

the third quarter." The market is now pricing in a peak fed funds rate of around 5.05%, he says.

Regarding the trade imbalances, Bernanke said in a letter to Sen. Robert Menendez of New Jersey that government policies would have a "limited" effect because the flow of funds into international financial markets is determined by "market perceptions of the relative attractiveness of U.S. and foreign assets."

Generally speaking, the existence of a deficit means that the U.S. is importing more goods and money than it exports, and that it must be financed by foreign purchases of U.S. securities. When it isn't, the dollar must fall or interest rates must rise, or a combination of the two, to make it attractive again for global investors to invest in U.S. assets.

Bernanke's Concerns

However, Glassman says that Tuesday's reading is a reminder that "a lot of dollar recycling is on autopilot. People do worry when they see a large current account deficit like the U.S. has, what will happen if foreigners stop investing. But foreign countries want their currency to be relatively stable to the dollar, so they have to recycle their surpluses back into the U.S. Otherwise their currency will rise and become less competitive."

Even though net foreign purchases remain strong, Bernanke expressed worries in the Menendez letter about the U.S. budget deficit.

"I am quite concerned about the intermediate to long-term federal budget outlook," the Fed chief said in the letter that followed up on his Feb. 16 testimony to the Senate Banking Committee.

"In particular, the budget is expected to come under severe pressure as impending demographic changes fuel rapid increases in entitlement spending. By holding down the growth of national saving and real capital accumulation, the prospective increase in the budget deficit will place at risk future living standards of our country," Bernanke said. "As a result, I think it would be very desirable to take concrete steps to lower the prospective path of the deficit," he said in the letter, which was dated March 9.

The Treasury has bumped up against its legislated national debt limit, and Treasury Secretary John Snow is now petitioning Congress to raise the ceiling on the nation's maximum credit limit. At $8.18 trillion, the current limit breaks down to nearly $30,000 for every person in the nation.

Congress and the Bush administration have been negotiating a roughly $781 billion extension for the current limit, and if it passes, it will be the fourth increase since 2002 and bring the total amount of additional government borrowing authority to more than $3 trillion since President Bush took office. (How does the debt limit affect you?

Click here for more.)

Other economic news weighing on the Treasury market includes the morning's stronger-than-expected jump in the March New York State manufacturing index, which rose 10 points to 31.2. The reading was well above expectations for the index to come in at 19.0, and is the highest reading since July 2004.

Import prices fell by 0.5% in February both with and without petroleum factored in, leaving core import prices up just 1.8% year over year. Overall import prices are up 7.4% since a year ago.

Meanwhile, the Mortgage Bankers Association said its mortgage applications index dipped by 0.2% last week, with purchasing applications up 1.0%. Refinancing fell by 1.9% and the fixed 30-year mortgage rate added 11 basis points to 6.42%.