Good news on inflation propelled Treasury prices into orbit yesterday, but weak demand at the first of this week's refunding auctions brought them back down to earth.

Still, prices closed the session in positive territory, with the 30-year bond ending 5/8 of a point higher to yield 6.13%. The benchmark bond had been up more than 1 1/4 points during the session.

Investors looking for clues on the market's health received conflicting signals yesterday, as the Treasury's three-year note auction failed to attract buyers, despite positive news on inflation and the resulting rally.

Note and bond prices surged in early trading as the market received more evidence of low inflation and relative weakness in the economy.

The Labor Department reported that its producer price index fell 0.2% in October while the core producer price index, which excludes the volatile food and energy components, plunged 0.5% in the month. Year-over-year, the producer price index was up just 0.2%. Market analysts generally expected an increase of 0.2% and 0.1% for the overall and core producer price indexes, respectively.

But prices came under selling pressure when the market got wind of a disappointing start to the Treasury Department's quarterly refunding. The three-year note auction was poorly bid at an average of 4.44% and a tail out to 4.46%.

The results were considerably worse that market expectations, observers said, emphasizing that the 1.97 bid-to-cover ratio indicates a lack of retail interest in the bidding. The results also cast an element of uncertainty into the Treasury's 10-year note auction today, an issue that has historically been a tougher sell than the three-year note.

After the auction results, the market gave up about half of the gains posted in response to the producer price figures.

"The three-year note sale was not spectacular, especially on the heals of such a good inflation report," said Robert Brusca, chief economist at Nikko Securities Co. International Inc.

Other factors of the market's retreat yesterday were a lack of retail interest late in the session and a healthy increase in the Johnson Redbook survey of weekly retail sales activity. According to the survey, sales rose 1.7% in the first week of October compared with sales in the first week of September.

Still, the focus of day was the producer price report. Economists were encouraged by the inflation figures and generally surprised by the huge 3.9% decline in prices of passenger cars. However, most noted that even excluding the auto component, producer prices fell by 0.1% at the finished level in October.

The Treasury market interpreted the unexpected decline in producer prices as an indication that businesses are unable to pass price increases on to customers and make them stick in the current economic environment.

The short end of the market rallied on the report, which calmed inflation fears and meant that the Federal Reserve Fed will not need to tighten credit in the near term.

"This report is a helpful development, and it shows that the pipeline isn't filled with demand price pressures," said William Sullivan, director of financial markets research at Dean Witter Reynolds Inc.

Sullivan said the producer price report was primarily a cars story. The drop in the auto component resulted from seasonal adjustments that had anticipated a 9% increase and taken into account quality improvements. Sullivan also noted that the intermediate goods component of the report was well controlled, falling 0.1% overall and holding unchanged excluding food and energy.

However, market observers cautioned that tomorrow's consumer price index could paint a slightly different picture of inflationary activity. Most agree the consumer price figures are likely to be affected by the the Clinton Administration's 4.3-cent gasoline tax, as well as by potential increases in prices for services and tuition.

"The real test will be the consumer price index," said Marilyn Schaja, money market economist at Donaldson, Lufkin & Jenrette Securities. "I think the report will show that consumer prices are not growing as rapidly as producer prices."

Analysts surveyed by The Bond Buyer generally expect an increase of 0.3% in overall producer prices at the finished level, and a rise of 0.2% in the core rate.

Should her forecasts for increases of 0.4% overall and 0.2% core materialize, Schaja said she does not believe this week's inflation series will negatively affect the Treasury market.

In futures, the December contract ended up 24/32 to 116.28.

In the cash markets, the 3 1/8% two-year note was quoted late yesterday up 1/32 at 99.19-99.20 to yield 4.07%. The 4 3/4% five-year note ended up 4/32 at 99.29-98.31 to yield 4.98%. The 5 3/4% 10-year note was up 6/32 at 100.28-101.00 to yield 5.61%, and the 6 1/4% 30-year bond was up 21/32 at 101.12-101.16 to yield 6.13%.

The three-month Treasury bill was unchanged at 3.11%. The six-month bill was down three basis points at 3.25%, and the year bill was unchanged at 3.38%. Treasury Market Yields Prev. Prev. Tuesday Week Month3-Month Bill 3.11 3.12 3.016-Month Bill 3.25 3.29 3.121 -Year Bill 3.38 3.43 3.222-Year Note 4.07 4.13 3.793-Year Note 4.34 4.40 4.055-Year Note 4.98 5.00 4.627-Year Note 5.19 5.21 4.8010-Year Note 5.61 5.59 5.2530-Year Bond 6.13 6.05 5.91Source: Cantor, Fitzgerald/Telerate

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