Long-term Treasury prices managed to improve yesterday morning despite the news that third-quarter output was much stronger than expected, and short-term prices joined in the rally in the wake of yesterday's successful two-year auction.

Late in the afternoon, the 30-year bond was up 5/8 point, to yield 7.61%, and Treasury notes were 1/8 to 5/8 point higher.

"For the first time in a while, we see across-the-board improvement in Treasury securities prices, with the long end up as much as 5/8 of a point," said William Sullivan, director of money market research at Dean Witter Reynolds Inc. "It's one of the strongest sessions for the bond sector in a while."

"The improvement is puzzling because [gross domestic product] showed more strength than allowed for and that would ordinarily be a somewhat unfriendly development, but nonetheless we were able to prosper," he added.

The domestic product rose 2.7% during the third quarter, when the consensus forecast called for only a 1.7% gain. During the second quarter, output increased 1.5%.

Treasury prices, which began to rise in overseas trading, dipped briefly on the gross domestic product report and then headed higher.

Traders said the market managed to respond positively partly because it reasoned that the gain in third-quarter output would boost President George Bush's chances for reelection.

And analysts said third-quarter growth was probably not as strong as the 2.7% increase in output suggested.

Some of the gain in gross domestic product came from inventory accumulation, and the overhang of inventories could depress production in the fourth quarter. And some of the categories that contributed to the report's strength, including inventories and exports, are based on Commerce Department estimates of September activity and could be revised drastically in coming months.

Analysts said the better-than-expected inflation numbers may have helped the bond market swallow the strong third-quarter growth.

The fixed-weight deflator rose only 2.1%, down from the 2.9% gain in the second quarter, when the consensus forecast called for a 2.6% increase, and the implicit price deflator was up 2.0%.

The deflators, along with the third-quarter employment cost index that was also released yesterday, showed that "inflation is just not a problem," said Paul Lally, an economist at R.H. Wrightson & Associates. "The employment cost index and the deflators both say that we can have stronger-than-expected growth and low inflation too."

The employment cost index, which tracks both wages and benefits, rose only 0.7% during the third quarter, matching the increase during the third-quarter of 1986, which was the lowest posted since the Labor Department began compiling the indicator in 1982.

The market got a friendlier number later in the morning, when the Conference Board said its consumer sentiment index dropped to 53.0 in October from a revised 57.3 September reading. That was a much larger decline than economists expected.

But Sullivan said the confidence report cast additional doubt on the gross domestic product report.

"If the economy is doing as well as the Department of Commerce officials said, that should be reflected in some genuine improvement in confidence," he said. "Instead, surveys are showing confidence eroded steadily through the third quarter and has continued to drop in the fourth quarter."

Traders said the price improvement after the gross domestic product report reflected some retail buying. The effects of that buying were exaggerated by the fact that many participants had established short positions because of the overwhelming pessimism about the presidential elections and the auctions, so the buying triggered short covering, traders said.

"You have a lot of people on the sidelines, but those who were involved were short," said Jay Goldinger, a market strategist at Capital Insight Inc. in Los Angeles.

The market held its gains going into the two-year sale even though the Federal Reserve bought bills for its own account early in the afternoon, in what the market calls a "bill pass." That was a disappointment to some traders who were hoping the Fed would buy coupons.

But the biggest surprise yesterday was the strong buying seen at the two-year auction.

At the time bids were entered, the two-year notes were quoted at 4.39% to 4.38%, and traders speculated the two-years might got at a 4.40% yield.

Instead, the government awarded the notes at the high of 4.37% and said the median bid was 4.35%. The Treasury Department is experimenting with the dutch auction method at two- and five-year auctions. In a dutch auction, all securities are awarded at the highest bid required to distribute all the securities.

Those who entered bids at the high got only 12% of what they requested.

"There were a lot of folks who bid for two-years who thought they were covering shorts not only in two's, but in fives," a government coupon trader said. "The result of that miss was a very expensive loss."

After the results came out, dealers' efforts to buy the new notes they needed in the secondary market pushed all short-term prices higher. By late in the day, the price of the new 4 1/4% two-years had risen enough to push yield down to 4.32% from the 4.37% level at which they were auctioned.

Despite yesterday's well-bid auction, many traders remain wary about today's sale of $10.75 billion of five-year notes.

Late yesterday, the when-issued five-years were bid at 5.83%, down from 5.91% late Monday.

"It's not necessarily going to follow that just because the two-year went well, the five-year will also," said James Kenney, head of Treasury trading at Prudential Securities. "I think there's a good chance it will not go as well, that we could trade five-years back to 5.90% between now and then."

The December bond futures contract closed 14/32 higher at 102 28/32.

In the cash market, the 7 1/4% 30-year bond was 5/8 higher, at 95 19/32-95 23/32, to yield 7.61%.

The 6 3/8% 10-year note rose 19/32, to 97 7/32-97 11/32, to yield 6.74%.

The three-year 4 5/8% note was up 10/32, at 99 18/32-99 20/32, to yield 4.76%.

Rates on Treasury bills were lower, with the three-month bill down two basis points at 2.95%, the six-month bill off two basis points at 3.20%, and the year bill six basis points lower at 3.35%.

Treasury Market Yields

Prev. Prev.

Tuesday Week Month

3-Month Bill 2.99 3.08 2.77

6-Month Bill 3.27 3.32 2.93

1-Year Bill 3.46 3.58 3.04

2-Year Note 4.25 4.30 3.80

3-Year Note 4.76 4.88 4.27

5-Year Note 5.78 5.90 5.32

7-Year Note 6.31 6.45 5.88

10-Year Note 6.74 6.87 6.36

30-Year Bond 7.61 7.64 7.36

Source: Cantor, Fitzgerald/Telerate

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