U.S. Treasuries boom as Fed vows to stay measured

Wed Jun 30, 2004
By Pedro Nicolaci da Costa

NEW YORK, June 30 (Reuters) - U.S. Treasuries rallied on Wednesday after the Federal Reserve raised official interest rates a quarter percentage point but maintained its pledge to be "measured" in future monetary tightening.

The market had been worried that recent upticks in inflation data would force the central bank to abandon its gradual approach to interest rate hikes.

But the Fed calmed bonds, saying that some of the inflation gains in recent months seemed to "have been due to transitory factors."

"Fed officials believe inflation expectations cause inflation," noted Christopher Low, chief economist at FTN Financial in New York. "So they have to be very careful what they say, otherwise it will make the situation worse."

Apparently the technique had the desired effect. The benchmark 10-year Treasury note (US10YT=RR: Quote, Profile, Research) was up 27/32 in price, lowering its yield to 4.58 percent from 4.69 percent late on Tuesday.

Two-year notes (US2YT=RR: Quote, Profile, Research) jumped 8/32, while yields dipped to 2.69 percent from 2.82 percent on Tuesday.

The five-year note (US5YT=RR: Quote, Profile, Research) added 18/32, taking yields to 3.77 percent from 3.90 percent. The 30-year bond yield (US30YT=RR: Quote, Profile, Research) fell to 5.29 percent from 5.37 percent.

Analysts said the Fed had essentially left itself enough room to adjust the pace of rate increases to future patterns of economic data.

"What the Fed has done has made further hikes conditional on inflation, and that works both ways. If inflation doesn't go up, then they are going to go slow," said Stan Jonas, managing director of derivatives at Fimat USA in New York.

The bond market on Wednesday at first keyed off a sharp drop in the Chicago Purchasing Management index of business conditions. The gauge dived to 56.4 in June when analysts had looked for only a slight pullback to 65.0 from 68.0 in May.

The new orders index plunged more than 17 points, dimming the outlook for manufacturing in the auto-intensive region.

Such softness in manufacturing, coupled with recent signs of a pullback in consumption, reinforced hopes the Fed can be gradual in tightening during the rest of the year.

"The Fed is nowhere near as hard-pressed as some of the critics seem to suggest," said Mark Vitner, an economist at Wachovia Securities in Charlotte, North Carolina.

"A lot of people are saying 'Can they really afford to do a quarter point each time?' With the economy growing at 3.5 percent instead of 5 percent, yes, they can," he added.

Such a view was reflected in the unwinding of curve-flattening trades -- bets that short-term yields would rise more quickly than those on longer-dated debt once tightening got underway.

Relief at the Fed's contained views on inflation helped steepen the yield curve, pushing the spread between two- and 10-year yields to 190 basis points from a near two-year low of 185 basis points.


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