Signs of economic strength and new Treasury supply are never a good recipe for success in the credit markets.
But that's exactly what investors have been treated to this week and yesterday was no exception.
The 30-year bond ended down almost 3/4 point, to yield 6.10%.
The market was greeted with more news that the economy is doing better and - against the backdrop of the Treasury Department's quarterly refunding - prices marched south in reaction.
The latest reading on the Federal Reserve's so-called Beige Book showed that economic growth in most regions of the country continued at a "slow to moderate" pace.
At first glance, market observers said the Fed's cautious assessment of the economy would not have a significant effect on the credit markets because they provided no new insight into overall economic conditions.
But in a display of just how vulnerable the market has become, sellers reacted to the Fed's report and sent prices lower. Most disturbing to market participants were the details of the report, which concluded that consumer spending rose in most Fed districts with particular strength in sales of automobiles and other durable goods. Auto sales were also said to be good in most regions.
"There is a risk that this kind of improved momentum will continue and the bond market is going through its typical drill of selling off on those expectations," said Stephen Roach, principal and senior economist at Morgan Stanley & Co. Inc.
After seeing heavy losses Monday during one of the busiest trading days this year, most dealers and investors were content yesterday to let positions hold. Trading activity slowed yesterday, which was welcome news for bond dealers, many of whom saw selling Monday from institutional customers that they had not done business with of any kind in several months.
Selling pressure yesterday was confined to the long-dated Treasury issues. Strong news on the economy and fear of upcoming supply took is toll on long-dated Treasuries. But those were just two of the many factors which have conspired to chip away at the market's recent gains.
Bill Feezer, head trader at Sanwa-BGK Securities, said the long end of the market traded lower in tandem with the Dow Jones utilities index, which ended down 35.77 points to 3661.87. Feezer said investors in fixed-income securities pay close attention to declines in the industrial index because it often signals higher interest rates.
The short end of the curve outperformed the rest of the market. Many participants felt the recent sell-off in short-dated Treasuries was over-done, but also because of a permanent addition of reserves. The Fed offered to buy bills of all maturities when the federal funds rate traded at 2 15/16.
Providing further support to the front end of the market was a move by many large accounts to shorten the duration of their portfolios.
"Dollar for dollar people are getting shorter," said Feezer, noting a strategy being employed by many accounts to gradually move in on the yield curve, which helped the short end remain in positive territory yesterday.
Feezer said investors were selling the 30-year bond for the 10-year note. They would then sell the 10-year and buy the five-year. And then accounts continued to swap Treasury issues until they achieve the desired maturities.
"People are taking a more conservative approach because the market is volatile and unpredictable," he said.
Anthony Karydakis, senior financial economist at First Chicago Capital Markets Inc., attributed the slow-down in trading activity yesterday to the Treasury's fourth quarter refunding and the reluctance of market participants to enter the market in fear of a surprise boost in issuance. The package, however, came in basically as expected.
The Treasury announced it will sell $29.0 billion of new securities in its quarterly refunding next week. The refunding will be composed of: $17.0 billion of three-year notes to be sold Tuesday, Nov. 9.; and $12.0 billion of 10-year notes to be sold Wednesday, Nov. 10.
The Treasury bumped-up the size of its 10-year issue, stemming from the department's stated policy of shifting its debt financing to shorter-term issues in the hopes of saving the government money. The Treasury also reopened the 5 3/4% 10-year note in order to increase liquidity in the issue, which market participants believe to be the subject of a protracted market squeeze.
As the debate rages over the direction of the economy, the market is trying to locate a comfort zone where it can tolerate stronger economic growth. Participants are bracing for the prospect of 4% growth or higher in coming months plus government-induced inflation as tax increases and health-care reform take effect. Until a level is agreed upon by the marketplace, Treasuries are in a rather tenuous position.
"We clearly do seem to have a pickup in gross domestic product growth and that has got people spooked," Stephen Slifer, a managing director at Lehman Government Securities Inc.
One potential problem for the market, Slifer added, is year-end pressures on accounts to lock in profits. Slifer predicts that more and more players will begin to take profits on existing positions in order to avoid big losses in the market. "The mindset is that people have had a good year and now they're getting neutral on the market and selling paper," he said.
Holding some large players in the Treasury market at bay is the positive inflation environment. While the market has clearly shown its displeasure for strong news on the economy, market observers believe the real sell-off will occur when inflation raises its ugly head again.
On the issue of inflation, Dallas Federal Reserve Bank President Robert McTeer said yesterday that recent economic reports are "encouraging" with inflationary pressures "relatively muted."
Speaking to reporters after moderating a panel on the North American Free Trade Agreement, McTeer would not comment directly on the likely outcome of the upcoming Federal Open Markets Committee meeting but said "we loosened (policy) from the spring of 1989 until mid-1992 and we've just stayed loose ever since."
In futures, the September contract ended down 2/32 to 116.19.
In the cash markets, the 3 7/8% two-year note was quoted late yesterday Up 1/32 at 99.16-99.17 to yield 4.12%, the 4 3/4% five-year note ended unchanged at 98.25-98.27 to yield 5.01%, the 5 3/4% 10-year note was down 7/32 at 100.24-100.28 to yield 5.63%, and the 6 1/4% 30-year bond was down 22/32 at 101.26-101.30 to yield 6.10%.
The three-month Treasury bill was down four basis points at 3.08%, the six-month bill was down four basis points at 3.25%, and the year bill was down two basis points at 3.41%.Treasury Market Yields Prev. Prev. Wednesday Week Month 3-Month Bill 3.08 3.08 2.986-Month Bill 3.25 3.19 3.101-Year Bill 3.41 3.34 3.222-Year Note 4.12 3.99 3.823-Year Note 4.39 4.24 4.095-Year Note 5.01 4.82 4.687-Year Note 5.23 5.00 4.8710-Year Note 5.63 5.43 5.3130-Year Bond 6.10 6.00 6.00 Source: Cantor, Fitzgerald/Telerate