The short end of the Treasury market is likely to attract about as much interest from investors this week as bonds backed by the Rwandan goverument.
Avoidance of short-dated Treasuries comes amid signs that the U.S. economy continues to grow apace and that the Federal Reserve will soon tighten monetary policy. Higher rates have made shortterm governments considerably less attractive in recent sessions and virtually ensured a weak performance by the short end this week. "Clearly, with the Fed hanging over that end of the market, there is no room for the short end to improve," said Jerry Zukowski, money market economist at PaineWebber Inc. "Bat the employment report has done is brought uncertainty back into the market."
Near term, the state of affairs at the long end of the maturity spectrum probably won't be much better. Evidence of economic expansion and higher wage pressures do not bode well for Treasuries in the intermediate and long sectors of the market. Still, losses at the long end are unlikely to be as deep because investors believe that stretch of the yield curve has the most to gain from tighter credit in the long run.
Bond investors' worst fears were validated Friday when the July employment report showed the economy is not slowing in the third quarter.
News of a gain of 259,000 jobs in July nonfarm payrolls discouraged market players who'd been looking for the report to support the view that the economy is slowing. Market observers had predicted that Treasuries would sell off with an above200,000 gain in payrolls.
Treasuries continued to plunge as dealers and retail accounts sold positions after the news, which fueled speculation that the Fed would tighten credit sooner than later. The 30year bond ended down almost 1 1/2 points Friday, to yield 7.54%.
June nonfarm payroll employment was revised to a 356,000 gain from an initially reported 379,000 gain. Average hourly earnings rose 0.4% with average weekly hours unchanged at 34.6 hours.
The short end took the brunt of the selling on the belief that the large July payrolls gain, coupled with rising wage pressures, will probably encourage the Fed to raise short-term interest rates at its Aug. 16 Federal Open Market Committee meeting, traders said.
Cary Leahey, senior economist at Lehman Government Securities Inc., said the Treasury market has built in expectations for at least a 25 basis point increase in the central bank's federal funds target rate. That prediction by dealers, he said, is in stark contrast with the market's expectations last week.
"The market has shifted from having an optimistic view of the Fed to expecting a tightening on Aug. 16," Leahey said, noting that the bond market is back to where it was before the report on second-quarter gross domestic product, which fueled speculation that the Fed would leave monetary policy unchanged.
In recent weeks, the market improved amid signs of slower growth in the economy and moderation in consumer spending patterns. That notion was supported by GDP growth in the second quarter that suggested softer economic fundamentals. But the July employment report probably returned the Fed to its original course of raising interest rates, analysts said.
Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson Inc., said Friday's jobs number, while apparently much bigger than the market expected, continued to point toward real growth of 3% to 4% in the economy. Wesbury also said he expects the central bank to raise both the federal funds and discount rates by 25 basis points at the FOMC meeting. The tightening move, he said, is justified more by rising commodities prices and a weak dollar than by accelerating growth.
Perhaps most damaging about the employment report is that it came ahead of this week's quarterly refunding auctions, when the market will absorb $40 billion in new government debt, observers said. Convincing retail accounts to buy Treasuries amid signs of continued growth in the economy will be no small feat, they said.
"That fact that people expect the Fed to tighten should leave a dark cloud over the refunding auctions," said John Canavan, analyst at Stone & McCarthy Research Associates. Canavan said many accounts will probably avoid bidding aggressively at the auction in hopes of buying the issues cheaper once the central bank tightens.
The Treasury Department is scheduled to sell $40 billion of notes and bonds this week to raise about $10.4 billion in new cash and redeem $29.6 billion of securities maturing Aug. 16.
The August refunding package will consist of $17 billion of threeyear notes to be auctioned Aug. 9, $12 billion of 10-year notes to be sold Aug. 10, and $11 billion of 30 1/4% bonds to be auctioned Aug. 11.
Market observers agreed Friday that the 10-year issue will be the toughest sell this week, particularly because it will be sold on the eve of potentially market-moving economic figures.
"The 10-year will be the trickiest auction ahead of the inflation report," said Anthony Karydakis, senior economist at First Chicago Capital Markets Inc. "People will be defensive bidding on the 10-year."
Among the hurdles the market must clear this week are the July producer price and July retail sales reports on Thursday and the July consumer price index on Friday.
In the futures market, the September bond contract ended down more than a point Friday at 103.03.
In the cash markets, the 6 1/8% two-year note ended down 15/32 at 99.26-99.27 to yield 6.20%. The 6 7/8% five-year note was down more than 3/4 of a point at 99.23-99.25 to yield 6.92%. The 7 1/4% 10-year note was down a point at 99.2499.28 to yield 7.26%. The 6 1/4% 30-year bond was down almost 1 1/2 points at 84.23-84.27 to yield 7.54%.
The three-month Treasury bill was up 13 basis points at 4.56%. The six-month bill was up 19 basis points at 5.08%. The year bill was up 21 basis points at 5.56%.
Corporate Securities
Moody's Investors Service Inc. said speculative bonds registered a total investment return of 0.35% in July, despite a bond price decline of 0.51%, according to Moody's Speculative Grade Total Return and Price Indexes.
Year to date, overall investment performance in the speculative-grade sector also registered a total return of 0.35%. Returns fell a sharp 2.85% in March and 0.39% in April of this year, but returns were positive during January, February, March, June, and July, Moody's said.
Over the previous 12 months, the speculative-grade market registered a 5.13% return. Total returns in this period were highest for bonds rated lower speculative-grade B3, at 5.92%. Bonds in the highest speculative-grade category of Baa registered the lowest total return, 2.92%, over the 12-month period during July 1994.
By comparison, speculative-grade bond returns for all of 1993 were 13%, 18% for all of 1992, and 39% for all of 1991.
Lea Carry, an economist at Moody's, attributes this year's modest returns in the speculative sector to the recent Fed rate increases and an overall decline in the coupon rates paid in the speculative-grade market.
The median coupon rate fell from 12.25% in January 1991 to 10.25% by January 1994. Lower coupon rates mean that the interest accrual component of total returns has been smaller this year than any of the previous three years, the rating agency said.
