Long-term Treasury prices broke with recent tradition yesterday and outperformed the short end decisively, as investors moved out the yield curve in search of better yields.
The 8% 30-year bond closed at the day's highs, up 5/8 point to yield 7.51%, while the 5% two-year note was down 1/32 to yield 4.22%.
As the long end outpaced the short end, the 30-year bond's yield advantage over the two-year note narrowed to 329 basis points from 337 late Friday.
"Flattening is the story of the day, that and the fact that we've made another new high in the bond contract," said Scott Winningham, chief market analyst at Stone & McCarthy Research Associates in Princeton, N.J.
Traders said the flood of supply due in the short end this week and fading hopes for another Fed easing may be scaring buyers away from short-term securities.
The Treasury will sell $15 billion of two-year notes today and $10.5 billion of five-year notes tomorrow.
The yield curve flattening began late last week, after Federal Reserve Chairman Alan Greenspan's Humphrey-Hawkins testimony. Some participants said his remarks may have discouraged investors expecting another Fed cut in short-term rates.
"People may take Chairman Greenspan at his word that the Fed can't do anything more to stimulate the economy by lowering interest rates," said Paul Kasriel, monetary economist at Northern Trust Co. "If the Fed isn't going to lower short rates, then the curve will flatten."
As the short end looses some of its appeal, the much higher yields available on longer-term paper are luring portfolio managers looking for better returns, traders said.
"It's really just a yield search going on," a government bond trader said.
A note trader said the flattening in the curve was being fueled by "dollar-for-dollar extension trades."
The note trader said he had seen many such extension trades since last Wednesday, with investors moving from short-term paper out to five- or 10-years, or just extending within the intermediate sector.
Traders said some of the buying yesterday reportedly came from owners of mortgage-backed securities who were worried that declining mortgage rates will result in heavy prepayments.
Yesterday's decline in commodity prices was another factor favoring the long end. The Commodity Research Bureau index closed .76 point lower at 204.09.
As investors have moved out the curve, the 30-year bond's yield advantage to the two-year note has fallen to 330 basis points, down from 337 late Friday.
Even though retail investors were reaching for longer, higher-yielding securities yesterday, traders were optimistic about this week's note auctions.
There are still plenty of participants interested in the short end, they said. Some participants still hope for another Fed easing, while many like the comfortable spread to the cost of financing. And traders said banks are expected to show up as usual to invest the money they are not lending to customers.
A short-term note trader said the likely 4 1/4% coupon on the two-year notes compares favorably to the 3 1/4% funds rate. "It's a safe place to play and get a decent return," he said.
The short-term trader said the easing of tensions with Iraq might also have something to do with the short end's poor performance yesterday, since it eliminated some flight-to-quality interest in short-term Treasury paper.
The September bond futures contract closed 14/32 higher at 104 3/32.
In the cash market, the 30-year 8% bond was 22/32 higher, at 105 91/32-105 23/32, to yield 7.51%
Treasury Market Yields
Monday Week Month
3-Month Bill 3.25 3.23 3.62
6-Month Bill 3.35 3.33 3.76
1-Year Bill 3.57 3.48 4.03
2-Year Note 4.22 4.23 4.80
3-Year Note 4.66 4.72 5.29
5-Year Note 5.63 5.79 6.26
7-Year Note 6.15 6.37 6.68
10-Year Note 6.66 6.88 7.09
15-Year Bond 7.03 7.25 7.40
30-Year Bond 7.51 7.65 7.76
Source: Cantor, Fitzgerald/Telerate
The 7 1/2% 10-year note rose 1/2 point, to 105 26/32-105 30/32, to yield 6.66%.
The three-year 5 7/8% note was down 1/32, at 103 2/32-103 4/32, to yield 4.66%.
In when-issued trading, the two-year note to be auctioned today was quoted at 4.30% and the five-year note to be sold tomorrow was yielding 5.67%.
Rates on Treasury bills were higher, with the three-month bill up four basis points at 3.21%, the six-month bill up three basis points at 3.28%, and the year bill two basis points higher at 3.45%.