The dollar gained but Treasury prices continued their recent decline Wednesday despite news that the U.S. trade deficit unexpectedly shrank in May.

Why the seeming disconnect? Both markets reacted to internal factors and remain guided near term by the outlook for U.S. interest rates. And despite the day's positive news about the trade and budget deficits, they are still major long-term concerns for both the dollar and bonds.

Beyond the headline, the narrowing of the trade deficit really was not that impressive. The deficit did fall to $55.3 billion in May from $56.9 billion in April, contrary to market expectations for the gap between imports and exports to rise to $57 billion.

But the change mostly came from a drop in energy prices in May. "With the volume of imported oil rising and prices having spiked, this will turn around in June with a vengeance," says Joel Naroff, president of Naroff Economic Advisors.

The deficit number gave traders an excuse to buy back the dollar, which had fallen for the five previous sessions. In recent trading, the dollar was at 112.085 yen vs. 110.85; the euro was at $1.2091, down from $1.2244.

After a big (and largely unexpected) rally in the first half of 2005, the greenback had recently been declining against the euro, mostly as central banks saw the cheaper euro as an opportunity to add to their reserves. Also, the European Central Bank seems less and less likely to cut interest rates, confounding previous market expectations.

But "any boost

from the trade deficit to the dollar should be short-lived," according to Naroff. Looking at the details of the report, U.S. consumers bought more foreign goods, especially motor vehicles. Demand for capital goods eased, showing that business spending remains cautious, and the bilateral deficit with China worsened, Naroff says.

While the greenback bounced, bonds were down slightly following a weaker-than-expected five-year note auction. The auction was a "red flag for the bond market that reinforces the current downtrend in prices," Tony Crescenzi, chief bond strategist at Miller Tabak, commented in

RealMoney.com's

Columnist Conversation. "Eyes are on the 200-day moving average for the 10-year, at about 4.20%."

The benchmark 10-year bond was recently trading down 2/32, while its yield rose to the key technical level of 4.15%. On Thursday, the government will auction $9 billion of 10-year Treasury Inflation Protected Securities (TIPS).

And while the Bush administration also revised downward its estimate of the budget deficit to $333 billion from $427 billion previously -- reducing the need to issue more debt -- the gap is still the third largest in history.

Ahead of the Curve

The bond market has been in a downtrend since last week, after the

Federal Reserve

gave no hint it might soon end -- or even pause -- its year-old campaign to raise rates.

Even if inflation pressures remain tame, economic growth is resilient enough to allow for rate hikes to continue, as shown in Friday's employment report and recent indications of stronger consumer confidence and retail sales.

Echoing Richmond Fed President Jeffrey Lacker on Monday, Philadelphia Fed President Anthony Santomero emphasized that point in a speech on Wednesday.

"While the recent inflation numbers have been good, and I share the general view that inflation is unlikely to be a problem in the near term, I believe that we must stay ahead of the curve to ensure that it does not become a problem in the long term," said Santomero, a voting member of the Federal Open Market Committee.

The bond market is also bracing for June consumer and producer price numbers Thursday and Friday, respectively, which are expected to show inflation remains tame.

While higher-than-expected numbers could trigger further downside for bonds, "the bond market knows it does not have to worry about inflation at this point," says Michael Gregory, interest rate strategist with BMO Nesbitt Burns.

Indeed, the market has revised upward its expectations of how far the Fed will raise rates this year, coinciding with a drop in future inflation expectations. The futures market currently expects the fed funds rate to stand at 4% by year-end, which represents another three quarter-point rate hikes over the next four Fed meetings.

Until more clarity emerges from the Fed or the economy, bond yields will likely be trading within their current range. For the yield of the 10-year bond, "a move back below 4% appears less and less likely," says BMO's Gregory.

But the yield will likely stay below 4.25% because global yields, especially in Europe, remain low, and that's exerting downward pressure on U.S. yields, he says.

Likewise, the dollar can remain supported at current levels -- after its recent impressive rally against the euro -- as long as the U.S. interest rate outlook remains tilted to the upside.

Thereafter, both the dollar and bonds will be subject to pressures from ongoing concerns about the trade and current account deficits, Gregory says.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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