Municipals dipped 1/4 to 3/8 of a point yesterday as signs of economic vigor weakened Treasuries and tax-exempts tagged along.

"All of [yesterday's] news on U.S economic activity favors higher interest rates," said John Lonski, senior economist at Moody's Investors Service.

The bond market yesterday learned that weekly claims for unemployment insurance for the week ended Sept. 24 dropped by 11,000. In addition, the increase in second-quarter gross domestic product was revised upward to 4.1% from 3.8% and sales of single-family homes rose by a much higher than expected 9.7% in August to a seasonally adjusted 703,000.

In yesterday's light to moderately active session, dollar bond prices sank 1/4 point, while yields on high-grade issues role by two basis points. In debt futures yesterday, the December municipal contract was down 1/4 point at 87 17/32. Yesterday's December MOB spread was negative 356, compared with negative 363 on Wednesday.

The market's "a snoozer ... grab a pillow," one municipal trader said, adding that "nobody wants to buy anything."

A second trader said it seems as if all the players are positioned as neutrally as possible.

"The volatility because of the neutral positions of most desks, [is] severe," he said. "Everybody has everything hedged ... you get more swings in the market than you normally wound because there's not one large long position out there overhanging the market, and there's not this one large short position out in the market."

In the government market, the benchmark 30-year bond dipped more than 1/4 point to post a 7.83% closing yield.

"I think perhaps the most noteworthy piece of news that we received today was one that did not receive a great deal of attention," Moody's Lonski said. "And that was the 11,000-worker drop in first-time jobless claims."

Lonski said it appears likely that first-time jobless claims will fall for a fourth consecutive month in September, a warning that September job creation could be "significantly greater" than the 179,000 new nonfarm jobs noted in the August employment report. The Labor Department will release its September jobs figures a week from today.

"Offhand, I'm looking for a gain of 280,000 jobs," Lonski said. "And I think that type of increase coupled with a faster pace of wage and salary growth, [and] a longer workweek could be enough to push the 30-year Treasury bond yields to up to about 7.95%."

So far, the credit market has been spared the typical wage escalation that usually follows a lower employment rate, but Lonski believes the bond market's luck could soon run out.

The market has added reason to brace itself because the August employment report was surprisingly weak, he said.

"Whereas the August employment report was surprisingly weak, it could very well be that the September employment report might be unexpectedly strong," Lonski said.

On the trade talk front, Lonski said "the successful completion of the on-going trade negotiations with Japan is not likely to provide much support to the credit market."

"To the contrary, were the trade talks to fail, that could do considerable harm to the bond market by further weakening the U.S. dollar against the yen," he said.

Failed talks could trigger an immediate five-basis-point rise by long-term Treasuries in response to a weak dollar versus the yen, he said. Lonski added that the market is continuing to see more evidence that the dollar's drop against the yen is heightening the inflation threat here.

Though he declined to say which one, Lonski said this week a major U.S. automaker suddenly thought it was capable of imposing a 5.5% price increase on a popular subcompact car, "partly in response to a reduced competitive threat from Japanese subcompacts."

As for what municipal bond investors should do in the current environment, Lonski, recommends staying short for now.

"One can only increase [his or her] exposure to interest sensitive securities very cautiously," Lonski said, "I do not believe that we are quite at the point where a wholesale lengthening of municipal bond maturities can be justified."

However, the economist said, it's much safer to lengthen the average maturity of a municipal bond portfolio today than it was a year ago when it was "a highly dangerous maneuver because of the historical lowness of interest rates, and the vulnerability to a rise by...treasury bond yields which indeed occurred."

While bonds are much more attractively priced today than they were a year ago, a peaking of municipal bond yields is still not in sight, he said.

"As long as bond investors continue to see the economy defy the Fed's attempts to sharply slow growth via interest rate hikes, bondholders will simply reduce their exposure to longer-term securities," Lonski said.

The Fed's tightening tour is not over, so that means much higher yields on short-term securities relative to long-term bonds, which means that conservative investors might do well to put a larger portion of their funds in money market securities, Lonski said. Such a move would minimize investors' near-term exposure to price risk, while maintaining their ability to lengthen maturities at what could be long yields that are 30 to 40 basis points higher than where they are today.

Turning to next week's new issues, a Dillon, Read & Co. group is expected to bring $240 million New York State Thruway Authority highway and bridge trust fund bonds. The negotiated slate also features $98 million California Statewide Communities Development Authority certificates of participation through Morgan, Stanley & Co.

Topping the competitive calendar are $160 million Maryland general obligation bonds.

In other news yesterday, the 30-day visible supply of municipal bonds totaled $2.14 billion, down $347.2 million from Wednesday. That comprised $1.095 billion of competitive bonds, down $62.1 million from Wednesday, and $1.04 billion of negotiated bonds, down $285 million.

Standard & Poor's Blue List of municipal bonds declined $29.3 million yesterday to $1.97 billion.

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