Treasury prices went through the roof yesterday as grim news on the economy and bright prospects for inflation returned sidelined retail and foreign investors to the market.

The 30-year bond ended up 40/32, to yield 6.56%.

The buy side of the market woke up after a week-long slumber yesterday and bought a healthy amount of securities across the yield curve.

Overall, market psychology took a sharp turn for the better as investors keyed off of signs that economic and inflationary growth remain tepid and that the budget deficit package may soon get the green light from Congress.

Action got under way early as note and bonds prices surged at the opening on a weaker-than-expected reading on gross domestic product.

The initial boost came as dealers covered a mountain of short positions that were established on expectations for a stronger report. The increase in prices was met with follow-through buying interest from the retail sector.

Reports that President Clinton is considering an executive order to control entitlement spending growth was a contributing factor to early price action.

But the real boom came late in the morning as foreign investors staggered into the market.

Volatility in European currency trading sent the U.S. dollar soaring and caused a flight out of Europe and into Treasuries. European currencies got whipped around yesterday in reaction to the German Bundesbank's failure to cut its discount rate.

That flurry of activity pushed the September bond contract much higher and brought on a bout of strong technical buying. The contract broke above the psychologically important 115.00 level, improving prospects for the market in the near term.

"The bond is in a world of its own, " said Joseph Liro, chief economist at S.G. Warburg & Co. "The GDP number was benign enough in terms of economic growth and mild enough in terms of inflation to bring in retail and foreign buyers."

The aggregate GDP rose just 1.6%, well below market expectations of a 2.2% increase. Participants were particularly enthused about the fixed-weight deflator contained in the report. The deflator came in at 2.6%, which was at or below market expectations.

Liro said the 30-year bond and the two-year note attracted the strongest demand during yesterday's rally because the GDP data supported the view that inflation remains under wraps and that a near-term tightening by the Federal Reserve is less likely.

"Activity at the short end of the curve reflects the market's relief that the economy remains soft, that inflation is on track, and on prospects for positive carry opportunities," Liro said. He said the two-year note at a yield of 4.10% over a steady 3% federal funds rate offers investors some insurance of 120 basis points of positive carry for at least a couple of months.

The buy side of the market was out in force yesterday as larger players were forced into the market to lock in higher yields as prices rallied and rates edged lower.

Jay Goldinger, chief investment officer at Los Angeles-based Capital Insight Inc., said that after the market's performance yesterday, retail accounts are more willing to put money to work.

"Psychology changed tremendously today." Goldinger said. "There was as much of a panic to get into the market today as there was to get out of it last week."

The bond futures contract had an impressive run yesterday. Traders attributed most of the buying early in the session to dealer short covering, followed by new buying through the afternoon.

Joseph Plauche, senior financial futures analyst at Dean Witter Reynolds, said that short-term sellers were forcing sellers to become buyers. "There was not technical resistance at all and we shot right up," he said.

On the international front, currency volatility has given the market safe-haven status. Interest rate differentials between the United States and most European nations had made dollar-denominated investments more attractive, particularly those in the intermediate sector of the yield curve.

"This is a period of severe tension and volatility in the European Exchange Mechanism and has sent investors to seek out safe havens," said John Rothfield, international economist and currency analyst at First Chicago Corp.

Currencies in the European Exchange Rate Mechanism have come under pressure and an increasing amount of volatility in recent sessions as 12 European countries move toward economic convergence.

As part of the nations' plan to issue a single currency by the end of the decade, all currencies are tied to the German mark and must trade within certain prescribed ranges of that benchmark.

The Bundesbank's failure to lower its discount rate yesterday not only disappointed the market, but has also tied the hands of many European countries that desperately need to cut rates to jumpstart their stumbling economies, according to currency analysts.

The good news for Treasuries is that the turmoil has just begun. Rothfield said the European central banks will probably try to muddle through a few more trading sessions and see if the situation corrects itself. Rothfield, like many currency experts, believes the volatility has only just begun.

"After a week's time the central banks may decide to suspend the ERM and allow exchange rates to float to level where they're comfortable with them," Rothfield said.

In late trading, the question in the Treasury market was how far the rally would go.

Steven Wood, director of financial markets research at Bank of America in San Francisco, believes the market will consolidate at or slightly above current levels as it awaits the July employment report due out next Friday.

Some downside risk will enter into the equation going into the Treasury Department's quarterly refunding, he said, but overall fundamentals are likely to stay positive.

On a purely technical level, the bond is likely to run into strong resistance at the 6.50% yield level. While the bond may break below that level, Wood said it probably will not be able to sustain the new level. "We need more news on the economy first, and it would certainly be helpful to get supply out of the way also," Wood said.

The market yesterday was able to weather a sharp rise in gold prices late in the afternoon. Gold surged to $400 an ounce, but attracted no noticeable market reaction.

One cause for concern may be some of the details of the GDP report. Looking at the date in terms of the overall economy, analysts said the numbers understated some strength in the economy.

Daniel Seto, an economist at Nikko Securities, said the overall number was skewed lower by a big drop in inventories and flat government spending. Business inventories rose $8.2 billion after surging $33.5 billion in the first quarter.

"That decrease in inventories is likely to translate into-stronger activity in the third and fourth quarters as the manufacturing sector rebuilds inventories," Seto said, noting that the 3.8% increase in personal consumption was another sign of strength.

Economists said that down the road, the market may take a closer look at the number and give back some of the gains achieved.

In other news, the jobless claims data released yesterday attracted little interest due to distortions caused by weather in the Midwest and the General Motors plant shutdown.

The Fed's weekly money supply figures also had little effect on the market. The M1 measure of money supply was flat in the week ended July 19, while M2 rose a scant $800 million. The broadest aggregate, M3, increased by $2.0 billion in the week ended July 19.

In the cash markets, the 4 1/8% two-year note was quoted late yesterday Up 6/32 at 100.08-100.09 to yield 4.10%; the 5 1/4% five-year note ended up 12/32 at 100. 17-100.19 to yield 5.11 %; the 6 1/4 % 10-year note was up 21/32 at 103.11-103.13 to yield 5.78%; and the 7 1/8% 30-year bond was up 40/32 at 107.08-107. 10 to yield 6.56%.

The three-month Treasury bill was down six basis points at 3.07%; the six-month bill was down four basis points at 3.25%; and the year bill was down eight basis point at 3.49%.

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