Municipal bond prices shot higher with Treasuries Friday, despite a larger-than-expected gain in November nonfarm payrolls.

"We're going to lag Treasuries, but we are definitely moving on the upside with" them, one trader said.

Municipal prices gained 3/4 point to a point overall, though more improvement was seen in spots at the close of Friday's fairly active session.

Yields on highgrade issues improved by eight basis points overall, while dollar bond prices gained a point.

In addition to the boost it received from Treasuries, the cash market was pulled up by the contract Friday, the trader said. The March municipal contract was up 1 14/32 to 85 1/32.

"I think that the muni contract is creating an arbitrage opportunity for people, so that the cash is kind of chasing that," the trader said.

The contract is perceived as rich to cash, prompting investors to buy cash and sell the contract, he added.

"Meanwhile, the contract keeps going up because people are buying the contract to sell Treasuries," he said. "So it's kind of the dog chasing his own tail."

Friday's March MOB spread was negative 442, compared with negative 452 on Thursday. In the government market, the 30-year bond was up 1 1/4 points to yield 7.89%. The gains came despite a 350,000 increase in nonfarm payrolls.

"Investors downplayed the very large increase by nonfarm payrolls and instead focused on the contraction of average hourly earnings and the average workweek," said John Lonski, senior economist at Moody's Investors Service.

Investors also ignored an increase in Columbia University's Leading Inflation Index, he said.

Lonski said that while short-covering may have played a role in Friday's rally, it was not the main factor.

"There seems to be a very strongly held belief that the economy is going to slow considerably in 1995," Lonski said. "I think it was in response to those very strongly held expectations that bonds managed to rally despite a much steeper than anticipated increase in nonfarm payrolls, as well as the sharp drop in the unemployment rate."

But Lonski suspects that belief may be flawed and said Friday's rally could be a mistake.

"I think the economy is strong and that it's going to do better than anticipated in 1995," he said, adding, "The only force that supports the argument of a significant slowing of U.S. economic activity in 1995 would be the loss of economic activity to the continuation of Fed tightening."

Aside from that, very little else exists to support the notion that the economy will slow in 1995, the economist said. The economy isn't seeing the excesses of supply over demand or the "dangerous speculative fervor" of the late 1980s, Lonski said.

While investors may believe that Fed tightening will slow the economy in 1995, Lonski said the central bank's actions so far have "not done a great deal of damage" to interest rate-sensitive purchases, such as motor vehicles.

"You could still argue that in some ways money is cheap," he said.

As for the next tightening move, Lonski sees a 60% chance for a 50-basispoint move at the Federal Open Market Committee meeting on Dec. 20.

"Repeatedly, the Federal Reserve Board governors have described the economy as being robust," he said. "Consequently, the Fed will most likely hike interest rates on Dec. 20 for the purpose of trying to cool off what appears to be an inflation-bound U.S. economy."

Lonski also sees possible inflation worries on the horizon. The drop in the employment rate to 5.6% in November from 5.8% in October should give employees more bargaining power, which eventually may lead to faster wage growth, he said.

Though investors took heart from the drop in average hourly earnings reported on Friday, the data only applies to nonsupervisory personnel. The data covers a number of unskilled workers who face foreign competition, he said.

The economist sees the employment rate continuing to decline. When that happens, consumer confidence will increase, and pent-up consumer demand will be unleashed, he said.

"I still believe that the labor market has yet to fully participate in this economic recovery," Lonski said. "As the participation of the labor market catches up with the overall economy, we will continue to be surprised by the vibrancy of consumer expenditures."

Also on Friday, AMG Data President Robert Adler said that the $193 million that flowed out of municipal bond funds for the week ended Nov. 30 was the smallest outflow since mid-October.

Seventy-five percent, or $172 billion, of the $230 billion of municipal bond fund assets tracked by AMG Data report on a weekly basis.

The 30-day visible supply of municipal bonds Friday totaled $3.18 billion, up $44.6 million from Thursday. That comprised $1.174 billion of competitive bonds, down $115.9 million from Thursday, and $2.011 billion of negotiated bonds, up $160.5 million from Thursday.

Standard & Poor's Blue List of municipal bonds was down $46.6 million Friday, to $1.37 billion.

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