Yields off on Europe debt worry, views on Fed

NEW YORK: Longer-dated US Treasury debt prices climbed on Tuesday on worries over the fallout from the European debt crisis and expectations the Federal Reserve will intervene to lower long-term interest rates.

Long-dated Treasuries soared early in the day, with benchmark yields dipping to their lowest levels in at least 60 years as Treasuries played catch-up to Monday's rally in euro zone government debt. US markets were closed on Monday for the Labor Day holiday.

Euro zone debt prices climbed with safety buying as worries mounted over the eventual outcome of the European debt crisis and its possible impact on the banking sector. In the euro zone, the Italian government scrambled to secure parliamentary backing for an austerity package as workers across Italy began a strike.

Treasuries gains were tempered following a sell-off in German government bonds. Gains were also reined in later in the morning after data showed the pace of expansion in the US services sector unexpectedly accelerated in August.

But the overall gloomy outlook for the economy continued to steer the course for longer-dated US debt.

"Clearly the developing economic picture supports the bullish action," said David Ader, head of government bond strategy at CRT Capital Group in Stamford, Connecticut.

Benchmark 10-year notes were trading 3/32 higher in price to yield 1.98 percent, down from 1.99 percent late Friday. Benchmark yields dipped to 1.908 percent overnight, marking the lowest level in at least 60 years.

Thirty-year Treasury bonds were trading 1-1/32 higher in price to yield 3.25 percent, down from 3.30 percent late Friday.

The US Treasury curve also continued to flatten amid growing speculation the Fed will move to extend the duration of its balance sheet by selling shorter-dated Treasuries in its portfolio and buying longer-dated debt.

The possibility that the US central bank will embark on the program, dubbed Operation Twist, has grown following data on Friday showing the US economy failed to create new jobs on a net basis in August, reviving fears of another recession.

A Reuters poll late last week found US primary dealers see an 80 percent chance the Fed will announce Operation Twist in the next six months, with many dealers saying they expect the central bank to announce the program at their next policy meeting on Sept. 20-21.

"The most likely next step will be duration extension, which was officially put on the table last week with a mention in the Federal Open Market Committee minutes," said Aneta Markowska, economist with Societe Generale in New York. "Importantly, Fed officials considered an active duration extension involving outright sales of short-term paper; this is in contrast with a passive extension where the Fed would reinvest mortgage-backed securities proceeds into the longer end of the Treasury curve.

"The only question that remains is when," she said.

The yield curve flattening narrowed the spread between two-year note yields and 10-year note yields to 177 basis points, a level last seen in March 2009.

Shorter-dated Treasuries dipped on expectation of some eventual Fed selling, with five-year notes trading 5/32 lower in price to yield 0.90 percent, up from 0.87 percent late Friday.

The Institute for Supply Management's services index for August came in at 53.3, beating forecasts for a dip to 51 from a July reading of 52.7. A reading above 50 indicates expansion in the sector.

"At the margin, it is an argument against any further accommodation at this point but this doesn't necessarily countervail the whole bulk of the other data," said Bill Jordan, economist at Ried Thunberg, a unit of ICAP in New York.

Copyright Reuters, 2011