Updated from 11:22 a.m. ESTTreasuries ended the session little changed Friday with a risk premium reintroduced into the yield curve after another quarter-point rate hike and inflation fears pushed bond prices lower all week. A spate of mild economic reports helped the market hold onto gains, as traders geared up for next Monday's readings on February construction spending and March manufacturing. But trade is likely to remain subdued until next Friday's all-important March nonfarm payroll numbers are released. The benchmark 10-year note edged higher 2/32 of a point to yield 4.85%. Bond prices and yields move in opposite directions. The 10-year yield touched 4.88% in intraday trading Thursday, the highest since May 14, 2004. Rick Klingman, chief Treasuries trader at ABN Amro, says this is the new key technical level for the note, up from 4.80% prior to this week's rapid rise in yields. The breach of the 4.80% technical level could signal an acceleration in "what is already a fairly dramatic move," say fixed-income strategists at BNP Paribas. The 30-year bond ended the session unchanged to yield 4.90%. In shorter-maturity debt, the two-year note edged higher 1/32 to yield 4.82% and the five-year added 2/32 to yield 4.81%. The yield curve has steepened out, with yields on the long end higher than those on the short end, which is what is expected. Longer-dated maturities usually yield more than their shorter-dated counterparts because it's riskier for investors to loan money for longer periods of time. Lately, the curve has been flat, and has even inverted, which could indicate that investors see more risk in the near term or they don't feel inflation will be as much of a problem going forward, so they don't feel the need for a risk premium on the back end.
But the Federal Reserve's decision Tuesday to raise the fed funds rate to 4.75% from 4.50%, along with hints that more rate hikes were on the way, sparked a slide in prices on the long end. "Economic growth has rebounded strongly in the current quarter but appears likely to moderate to a more sustainable pace," said the policy-setting Federal Open Market Committee in the statement that accompanied its 15th-straight rate hike. "The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance." Fed funds futures now show 100% odds that central bankers will raise the target rate to 5% at their next meeting in May. Odds for a move to 5.25% in June are about 30%, up from zero last week. And Barclays Capital believes the overnight lending rate will hit 5.5% by the end of the year. Interest rates on home mortgages and bank loans to corporations rise and fall in tandem with Treasury yields, and the eventual result of higher rates will be a slowdown in economic activity. "A risk premium is priced in here and is here to stay," says Matthew Smith, vice president and fixed income portfolio manager at Smith Affiliated Capital. "We won't get much movement to the upside because of the amount of data that needs to come out before we can guess at
when the Fed will stop raising rates." Some market watchers, including Michael Darda at MKM Partners, say the bond market has been vastly overpriced, and that a correction is long overdue. He attributes low yields and high prices on Treasuries to the fact that there is a lot of easy money still floating in the world and few "safe" places to invest.
But Smith argues that if Treasuries are the best place to invest, since they give the highest return for the least risk, then they're not overpriced. The only thing that will take foreign investment dollars out of Treasuries is protectionist legislation out of Washington," Smith says. It's up for debate whether such legislation would actually become law, but in an election it's hard to deny that politicians may beat the drums of economic protectionism in exchange for votes. Countries like China and members of OPEC may not feel like loaning the U.S. money in the form of Treasury buying if they believe they will be kept from direct business investment in the U.S. The Federal Reserve reported that foreign holdings of treasury and agency debt rose by $5.24 billion over the past week, with Treasuries seeing a pop of $4.435 billion to a daily average of $1.128 trillion. Foreign investors hold more than half of all Treasury debt. In the day's economic reports, the Commerce Department said that personal income rose by 0.3% in February, down from a 0.7% gain in January and less than the 0.4% rise forecast by Wall Street economists. Personal spending rose by 0.1%, vs. expectations for spending to remain flat, but January's 0.9% jump was downwardly revised to a 0.8% gain. More importantly, the personal consumption expenditures number, one of the Fed's favorite inflation measures, was flat and the core PCE number rose by 0.1%, after a 0.2% gain in January. This leaves core-PCE growth at 1.8% year-on-year, below the Fed's 2% estimate for 2006. Central bankers are watching core inflation rates to see whether higher energy and commodity prices have worked their way into core prices. Thomas Hoenig, president of the Kansas City Fed, said in a speech Friday morning that inflation will remain at the current level in 2006, and that the core inflation rate is "encouraging."
Moreover, the Commerce Department said that February factory orders rose a less-than-expected 0.2%, vs. estimates for a 1.3% gain. But there were also sign of economic strength in Friday's economic reports, with the Chicago PMI manufacturing index rebounding to a strong 60.4 in March from 54.9 the prior month, vs. estimates for a smaller gain to 57. The new orders and production components both posted gains, and they are looked at to provide a forward reading on manufacturing activity. Prices paid edged lower and employment rose. The upbeat report could mean that next Monday's national manufacturing index will show a robust gain as well. The University of Michigan's consumer sentiment report for March was revised to show a 2.2 point rise to 88.9 vs. a previously reported flat reading.