US Treasury prices fell on Friday after a surprisingly strong survey of manufacturing in the Midwest overshadowed soft readings on inflation and consumer sentiment.
The benchmark 10-year Treasury note slipped 11/32 in price, lifting its yield to 4.65 percent from 4.60 percent late Thursday. Nevertheless, yields are still down 11 basis points for the week, the best performance in three months of relentless increases.
The morning's data showed restrained inflation and consumers becoming more gloomy, but also surprising strength in Midwest manufacturing. All this did nothing to change views that the Fed will hike interest rates next month, though the tempering of inflation was enough to calm fears of an even more aggressive tightening campaign.
"Inflation is creeping up, but it's not out of hand. I think that's pretty important," said Gary Thayer, chief economist at A.G. Edwards and Sons. "The bond market may have discounted a worst-case scenario over the last couple of months on inflation, and now maybe traders won't have to worry about the Fed moving too fast."
That allowed Treasuries to hold gains for the week even after the day's losses. Five-year notes dropped 9/32 in price, nudging yields to 3.80 percent from 3.73 percent late Thursday, but still down from 3.90 percent a week ago.
The 30-year bond lost 12/32, taking its yield to 5.34 percent from 5.32 percent. Two-year yields rose to 2.54 percent from 2.47 percent.
Traders said some buying was motivated by money managers' need to adjust their average portfolio durations to benchmark indexes. The much-followed Lehman Treasury index is extending by a hefty 0.15 year this month and indexed funds may need to pick up longer-dated debt to match it, leading to a flattening of the yield curve.
Still, the fact remains that the Fed will almost certainly raise interest rates this year, an event that rarely favours fixed-income debt.
"We're looking for rates to end the year at 2.0 percent and we expect the Fed to speed up its tightening next year," said Ram Bhagavatula, chief economist at RBS Financial Markets.
"That means Treasuries should be sold at every opportunity, like after this week's gains for instance," he added.
Strength in the Chicago Purchasing Management index of business activity backed up that argument. The index jumped to 68.0 in May, when economists had looked for a modest pullback to 61.0 after April's already robust 63.9. The employment index also firmed, pointing to some improvement in the labour market.
"This is a very stunning report. The Chicago PMI is a volatile series and I thought you'd get some retracement and you didn't," said an impressed Joseph LaVorgna, senior US economist at Deutsche Bank Securities.
In contrast, the final University of Michigan consumer sentiment index for May surprised by dipping to 90.2. Analysts had expected a steady 94.2. Analysts blamed Iraq and rising gasoline prices for the pullback, which came despite generally upbeat news on the economy this month.
Treasuries bounced earlier when the price index for core personal consumption expenditures, one of the Fed's favoured inflation gauges, rose only 0.1 percent in April, below forecasts of a 0.2 percent gain.
Downward revisions to past data meant the annual rate edged up to only 1.4 percent. Many analysts had looked for a rise to 1.6 percent.
Traders said activity was light before the end of the trading session at 2 p.m. ahead of the three-day US Memorial Day holiday weekend.
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