Treasury prices rallied Friday morning when a modest increase in May consumer prices calmed the market's inflation fears and increased the chances for another Fed easing.
The Treasury market gave back about half of its initial gains later in the day as participants sold securities to take profits ahead of the weekend, but traders said the market's tone remained firm.
Late in the afternoon, the 30-year bond was up 1/4 point on the day, but down 3/8 from the day's high, and yielded 7.85%, while short-term notes were 1/8 to 1/4 point higher.
May consumer prices rose only 0.1%, below the consensus forecast of a 0.3% rise. The 0.2% gain in the core rate of May prices, excluding food and energy costs, was also below the 0.3% increase the market expected.
The moderate increase in consumer prices was especially good news after the 0.6% jump in the core rate of May producer prices that was reported Thursday.
Analysts said the surge in the core rate of producer prices was a fluke that reflected huge one-time increases in tobacco and commercial aircraft prices, but the numbers were still unsettling to the bond market.
Kathleen Camilli, chief economist at Ramirez Capital Consultants, said the market's inflation fears had been building even before the producer price report came out, fed by some articles in the press suggesting the economic recovery would result in renewed price pressures.
The May consumer prices "should allay any fears of a resurgence in inflation," Ms. Camilli said.
The May consumer price statistics showed food prices fell 0.3%, led by a drop in fruit and vegetable prices, while energy prices rose 0.6%.
Ms. Camilli said a 3.2% drop in air fares and the modest 0.1% increase in home owners' costs helped keep the overall increase modest in May. Even the perennial villain of the consumer price report, health care, was up a little less than usual at 0.5%.
Analysts agreed the good news on consumer prices gives the Federal Reserve more leeway to ease rates, but they were divided on whether the Fed will take advantage of that leeway.
David Wyss, chief financial economist at DRI/McGraw-Hill, said the Fed's belief that the recovery has begun, along with lingering inflation fears, will keep policy on hold.
"The Fed's walking a tough line right now," he said, adding that it was his guess that the Fed would not ease.
But Michael Moran, chief economist at Daiwa Securities International, said given the favorable inflation report, the Fed would ease monetary policy if it gets any economic news that shows the recovery is lagging.
"The Fed will move quickly if you see even a hint of weakness in these numbers coming up, like housing starts or durable goods," Mr. Moran said.
The Fed took pains Friday morning to indicate it had not altered policy by draining reserves with matched sales-purchase agreements when the funds rate was trading below the Fed's current target.
The rest of Friday's economic news had little impact on Treasury prices. Business inventories for April were up 0.1%, when the market expected no change, with the gain resulting from a 1.1% jump in retail inventories. Real earnings for May rose 0.4%.
The market priced in the good news on inflation immediately after the consumer price report came out and traded near the highs through the morning, before beginning to drift lower at midday.
Traders said it was a mistake to read too much into the afternoon sell-off, which they blamed on profit-taking ahead of the weekend.
Instead, many asserted that the market's positive technical situation would continue to support prices this week.
"The Street's in good technical shape," a government bond salesman said. "They don't have much paper, and retail's definitely on the buy side, not the sell side."
A coupon trader said, "This market is charging ahead bit by bit every day."
The trader said he would be surprised to see the market falter. "We're not worried about inflation anymore, and [Thursday's] retail sales number showed the consumer isn't doing anything," he said.
Economists said the Treasury market will remain in a narrow trading range, with the 30-year bond continuing to trade between 7 3/4% and 8%.
"We could stay in that range through the election," Mr. Wyss said. "It looks like a very boring market right now."
If anything, he argued, this week's numbers are likely to depress Treasury prices, since most of the indicators should be bullish for the economy.
Mr. Wyss expects today's early-June car sales to match the stronger 6.5 million rate seen in late May. He is predicting a 3% gain in tomorrow's May housing starts and a 0.5% increase in May industrial production, which will also be released tomorrow.
The September bond futures contract closed 11/32 higher at 99-20/32.
In the cash market, the 30-year 8% bond was 7/32 higher, at 101-17/32-101-21/32, to yield 7.85%.
The 7-1/2% 10-year note rose 9/32, to 101-15/32-101-19/32, to yield 7.27%.
The three-year 5-7/8% note was up 5/32, at 100-27/32-100-29/32, to yield 5.53%.
Rates on Treasury bills were mixed, with the three-month bill up two basis points at 3.67%, the six-month bill down two basis points at 3.76%, and the year bill one basis point lower at 3.96%.