The short and intermediate sectors of the curve led an impressive rally yesterday, ignited by a strong Treasury auction and healthy buying from municipalities.

The 30-year bond ended up 11/32, to yield 6.19%.

The rally caught the market off guard and forced many participants to purchase securities.

Dealers were caught on the wrong side of both the cash and futures markets yesterday as prices surged across the yield curve, forcing them to buy back positions established earlier in the session.

Short covering accounted for the bulk of the buying. Traders said many in the market had established short positions in anticipation that the market would react badly to tepid demand for the auction.

But solid demand emerged and dragged prices higher across the yield curve and propelled the long bond briefly to a new record low yield of 6.18%, the lowest yield in 16 years.

"People got short-squeezed after the auction." said Michael Strauss, chief economist at Yamaichi Securities. "The front end of the market led the rally and took people by surprise."

The September bond futures contract surged in tandem with the cash market, and participants were forced to buy back bonds before the market moved even higher.

The Treasury set a 3 7/8% coupon on $16 billion in two-year notes it auctioned at a 3.94% yield, a price of 99.876. Market expectations were for the issue to go for a 3.96%. Traders said the bid-to-cover ratio was impressive at 3.49.

Dealers reported strong retail bidding for the issue. Bank portfolios were also major purchasers, they said. The strength of the auction was attributed to positive fundamentals and technicals, which participants said continue to underpin the market on its grind toward lower yields.

"Today's rally was a sign that people are comfortable with the market and with the [Federal Reserve's] stance on the economy," said Tony Crecenzi, head trader at Miller, Tabak, Hirsch & Co.

The rally was was led by the short end of the market for a change, traders said. in recent weeks, the long end has routinely outperformed other sectors of the yield as the market grew more comfortable with the outlook for inflation.

But yesterday, the short-dated paper regained the spotlight as investors took note of the ease with Which the short end absorbed new supply.

Another plus for the short end is the market's belief that steady Fed policy and a stable short-term interest rate environment will preserve an investor's rate of return. "Stability at the front end makes carry gains more attractive." Cresenzi said.

While the short end led the rally Yesterday, the intermediate sector outperformed the rest of the curve on the back of municipal defeasance buying. The seven- and 10-year notes were the star performers in yesterday's market as municipalities pooled money into Treasuries.

"Buying by municipalities remains a solid area of support for the market." said Strauss of Yamaichi.

The Treasury's announcement that it was cutting back the size of the weekly bill auction by $800 million to $23.6 billion added to the market's euphoria yesterday and supplied further support for short-dated paper, traders said.

Yesterday's bullish price action allowed the market to shrug off stronger-than-expected auto sales figures. According to Stone & McCarthy Research Associates in Princeton, N.J., auto sales weighed in at a rate of 7.0 million units, compared with an expected rate of 5.8 million units.

The next hurdle this week is today's five-year note auction. Most expect the age of $11 billion in five-years to go without a hitch as continued support from municipalities and bank portfolios continue to support the intermediate sector of the curve.

"The market is in very good shape for the auctions this week," said Scott Winningham, chief market analyst at Stone & McCarthy.

On the economic data calendar, the Commerce Department will release its durable goods orders, report for July. Most participants expect a flattish figure or a slight decline.

In futures, the September contract ended Up 22/32 to 117.31.

In the cash markets, the 4 1/4% two-year note was quoted late yesterday Up 5/32 at 100.23-100.24 to yield 3.84%; the 5 1/4% five-year note ended up 13/32 at 101.19-101.21 to yield 4.86%; the 5 3/4% 10-year note was up 15/32 at 101.17-101.19 to yield 5.54%; and the 6 1/4% 30-year bond was up 11/32 at 100.22-100.24 to yield 6.19%.

The three-month Treasury bill was down two basis points at 3.00%; the six-month bill was down two basis points at 3.10%; and the year bill was down five basis points at 3.24%.Treasury Market Yields Prev. Prev. Tuesday Week Month3-Month Bill 3.04 3.06 3.086-Month Bill 3.17 3.20 3.251-Year Bill 3.34 3.39 3.482-Year Note 3.84 3.98 4.083-Year Note 4.20 4.37 4.365-Year Note 4.86 5.06 5.127-Year Note 5.13 5.34 5.4210-Year Note 5.54 5.70 5.8030-Year Bond 6.19 6.30 6.44

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