Yields on The Bond Buyer's municipal bond indexes dropped to their lowest levels since January, as light supply and hopes of an easing in Federal Reserve Board policy kept the municipal market's tone firm for most of the week.

The average yield to maturity of the 40 general obligation and revenue bonds used in the daily Municipal Bond Index fell two basis points, to 6.61% from 6.63% last Thursday. On Wednesday, the yield to maturity fell to 6.6.%, its lowest level since The Bond Buyer began calculating the yield on Jan. 1, 1985.

The 20-bond index of GO bonds decreased three basis points, to 6.51% from 6.54%, while the 11-bond GO index dropped one basis point, to 6.40% from 6.41%. They are now at their lowest levels since Jan. 9, when the 20-bond index was 6.40% and the 11-bond index was 6.28%. The Jan. 9 figures were the lowest for the indexes since mid-1979.

The 30-year revenue bond index's yield was off one basis point, to 6.69% from 6.70% a week ago. It has not been lower since Jan. 16, when it was 6.66%, but it remains well above its all-time low of 6.53%, set on Jan. 9.

Municipal bonds performed slightly better than long-term U.S. Treasury bonds, as the bellwether 30-year bond's yield was unchanged at 7.85% for the week.

In short-term municipal market, The Bond Buyer's one-year note index declined five basis points, to 3.34% from 3.39% last week.

Earlier in the week, the municipal market took its cue from the previous week as traders expected increased investor demand, light supply, and hopes of an easing in monetary policy to keep the market bullish.

"We're seeing an orderly flow of bonds, good movement, and inquiries," said a Chicago-based trader. "People are adjusting to the new levels, and we're seeing demand increase as more people jump on the wagon. You get a sense that people don't want to miss out on this move to higher levels."

The markets remained firm on the strength of investor demand and were bolstered by Tuesday's Commerce Department report that housing starts plunged 17% in April, to a seasonally adjusted annual rate of 1,115,000 units. The 17% decline was the largest since -March 1984, when housing starts fell 26%.

Although the Fed had not eased by then, market participants remained hopeful that an interest rate cut would come later this week.

"People don't feel like selling," a government bond trader said. "After this morning's number, you have to still think the Fed will ease and they're willing to wait."

Those hopes began to fade late Wednesday morning, however, when it became apparent that the Fed would not be changing its policy leading to as sell-off that turned increasngly sour throughout the day.

After yesterday's larger-that-expected 20,000 drop in initial state unemployment insurance claims, to a seasonally adjusted 406,000 in the week ended May 9, the market also began worrying about the high price levels that tax-exempts had reached.

"The market is incredibly fragile," a Wall Street-based trader said. "The music faltered and everybody's scrambling for a chair. Guys who thought they were buying from strength suddenly found themselves at the top looking down."

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