Treasuries Up, Economic Doubt Energizes

Fri Aug 6, 2004
By Wayne Cole

NEW YORK (Reuters) - U.S. Treasuries staged a huge rally on Friday after a surprisingly weak reading on U.S. jobs challenged official optimism that the economy would bounce back strongly after a slowdown last quarter.

With the economy adding only 32,000 jobs in July -- in sharp contrast to the 228,000 expected -- investors scaled back expectations for how far the Federal Reserve would raise interest rates this year.

Although most still expect a quarter-point hike at the Fed's meeting next week, they see a significant chance that the pace of moves will slow thereafter.

The benchmark 10-year note (US10YT=RR: Quote, Profile, Research) leaped 1-13/32 in price, sending yields crashing to 4.23 percent from 4.41 percent late Thursday. At one stage yields delved as deep as 4.16 percent, the lowest level since April and a world away from the 4.65 percent highs hit just last month.

"If we get another jobs report as weak as this, there's no way the Fed will hike in September," said James Glassman, senior economist at J.P. Morgan. The Fed has four more meetings left this year and the market had thought it would raise rates at each one, taking them to 2.25 percent in time for Christmas.

Interest rate futures (0#FF:: Quote, Profile, Research) now show investors betting that rates will be at 2.00 percent or less by year-end and that the pace of tightening will slow further in 2005.

Likewise, short-term yields, which are the most sensitive to the outlook for official rates, shifted lower to reflect the new reality. Two-year yields (US2YT=RR: Quote, Profile, Research) slid 25 basis points to 2.38 percent, the biggest one-day fall in almost a year.

Five-year notes (US5YT=RR: Quote, Profile, Research) climbed 31/32 in price, driving yields down to 3.40 percent from 3.61 percent on Thursday. Thirty-year bonds (US30YT=RR: Quote, Profile, Research) rose 1-24/32, while their yield dropped to 5.04 percent from 5.17 percent.

"The apparent slowing of the economy also suggests that the inflation scare of recent months was premature," said Glassman at J.P. Morgan. "That in turn suggests it's safe to reenter the carry trade."

Borrowing at low short-term rates to buy higher-yielding long-dated paper has been a favored trade in recent years but had been going out of fashion as the Fed talked about raising rates to more neutral levels.

The first sign of a revival in the carry trade was a steepening in the yield curve, with the gap between two- and 10-year yields widening 7 basis points to 1.86 percentage points.

THOSE JOB NUMBERS AGAIN
Nonfarm payrolls rose just 32,000 in July, when median forecasts had called for a 228,000 gain, and June's rise was revised down to 78,000 from the original 112,000. The unemployment rate did dip to 5.5 percent from 5.6 percent but was overshadowed by the payrolls figures.

"I find this number stunning," said Stephen Stanley, chief economist at RBS Greenwich Capital "One bad number in June could be written off, but two in a row -- obviously, there's something more fundamental going on."

The weakness in jobs would be a particular blow to Fed Chairman Alan Greenspan given the unambiguously optimistic outlook on the economy he presented to the House in testimony last month.

Equities also took the data hard, with the Standard & Poor's 500 index shattering major chart support to hit its lowest level this year -- a very bearish event, according to analysts.

The slump made fixed-income debt more attractive in comparison and, if sustained, threatened to be a drag on the economy by crimping investor wealth and business confidence.

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