Updated from 12:06 p.m. ESTA trifecta of ramped-up growth in the U.S. service sector, rising inflation in Japan and higher energy prices took the wind out of Treasuries Friday, sending the yield on the benchmark 10-year note to its highest level in a year. The market will pay close attention to next week's readings on factory orders and payrolls, since recent strong readings have pushed Lehman Brothers economists to raise their fed funds rate target to 5.5% by August or September. The firm, one of the 22 primary dealers of U.S. government securities that trade with the Fed, also expects rates to hit 5% next quarter and stay at least at that level throughout the year. "It's simply a matter of the overall level of strength we see in the economy," says Drew Matus, Lehman's senior U.S. economist with a specialty in fixed-income markets. "There are no signs of a slowdown in the near term, and the economy is approaching inflation thresholds from the capacity utilization and from the unemployment sides," he says, adding that would be "enough to keep the Fed raising rates in order to contain an inflation outbreak." The benchmark 10-year note ended the day down 14/32 of a point to yield 4.69%. The yield is up 11 basis points this week, the biggest jump since the week ended Jan. 27, when it gained 16 basis points. It is also at its highest level since March 23, 2005, according to Reuters data. The 30-year bond tumbled 25/32 to yield 4.66%, the five-year lost 6/32 to yield 4.71%, and the two-year slipped two ticks to yield 4.75%. Bond prices and yields move in opposite directions. The Institute for Supply Management's services sector index for February supported claims made by Lehman and Matus that the economy is on firm footing, rising to 60.1 from 56.8 in the previous month. Wall Street forecasts had called for a rise to 58.0. Any reading over 50 implies expansion relative to the prior month.
The employment component posted the biggest gain, hitting 58.2, the highest reading since Aug 2005 when it was at 59.6. The prices paid component dipped to 64.8 from 67.2 in the previous month, but David Ader, chief U.S. government bond strategist at RBS Greenwich Capital, says the downtick will be largely ignored because prices are still elevated. He adds, "
the gain in employment raises the risk of higher nonfarm payrolls gains," referring to the February employment report due out next Friday. News on consumer prices in Japan also weighed on the U.S. Treasury market. Japan's core CPI, excluding fresh food prices, was up 0.5% year-over-year, the biggest annual increase in nearly eight years and above consensus forecasts for a 0.4% gain. The results raised expectations that the Bank of Japan could scrap its ultraeasy monetary policy, which has long kept the overnight lending rate in the world's second-largest economy at 0% in a bid to fight deflation. Tony Crescenzi, chief bond market strategist at Miller Tabak and a RealMoney.com contributor, says that if interest rates worldwide rise, that could make Treasuries less attractive to foreign investors. The reason is that as rates go higher around the world, the Treasury market may no longer be the only safe haven where foreign investors can get a real return. The European Central Bank raised rates by a quarter of a point on Thursday to 2.50%, its second hike in the last three months, and indicated more increases could be coming down the road. Higher oil prices also contributed to the negative bond market sentiment, as tensions in Iran kept crude rising. Light, sweet crude for April delivery tacked on another 11 cents to $63.47 Friday. ( Click here for more.) Meanwhile, Fed Vice Chairman Roger Ferguson, who resigns from his post effective April 28, said that he sees the economy as "solidly on track." But in the speech made at Howard University, he also said energy prices are one of the key factors that could affect the inflation picture and the Fed's interest-rate policymaking.
In other economic news, the University of Michigan's revised consumer sentiment report for the month of February was downwardly revised to 86.7 from its preliminary reading at 87.4. The index hit 91.2 in January. Matus points out that consumer confidence surveys haven't necessarily correlated with consumer spending in recent months. He believes that a deceleration of growth in the housing market will be offset by larger paychecks. "With income growth, there's just really no reason to expect that a housing slowdown is going to be a major factor slowing the economy," he says.