US Treasury debt rallied on Tuesday as investors shrugged off warnings about inflation from the Federal Reserve and bet slower economic growth would be the most crippling consequence of record oil prices. Gains were heftiest in short-term debt, where two-year note yields posted their largest one-day drop of the year.
Minutes from the US central bank's August 9 meeting showed officials were increasingly concerned about price increases, with most participants saying they viewed inflation risks as having "ticked up."
But as crude oil hit yet another record high just below $71 a barrel, traders seized instead on the part of the Fed's remarks that suggested it was worried the energy shock might force a slowdown in consumer spending.
"People are focusing on the impact of higher energy prices on the consumer instead of focusing on the impact of higher energy prices on inflation," said Drew Matus, senior financial economist at Lehman Brothers.
This emphasis was evident in the price action, with the market rising further after the minutes were released.
Benchmark 10-year notes climbed 20/32 for a yield of 4.10 percent, their lowest in two months and down from 4.17 percent on Monday. Two-year notes surged 6/32 for a yield of 3.95 percent, down from 4.06 percent.
Heavy buying was also apparent in futures, where the implied chance of a December interest rate hike from the Fed fell sharply, to about one-third from 58 percent on Monday.
Some analysts noted that the continued spike in oil prices had altered the financial landscape since the Fed sat down to decide on monetary policy earlier this month.
Indeed, it seemed bond investors were becoming convinced that even the resilient US consumer will not be able put up with such a huge energy burden, particularly with heating oil demand expected to jump in the coming months.
"The market is viewing these extraordinarily high oil prices as a tax on the consumer," said Mary Ann Hurley, senior Treasuries trader at D.A. Davidson. "This is going to nip spending in the bud."
This conviction has been behind the steady gains racked up during the month of August.
The sense that the economy will suffer the brunt of energy costs might explain while the market kept on rising despite a surprising improvement in consumers' moods for August.
The Conference Board on Tuesday said its consumer confidence index rose in August to 105.6 from a revised 103.6 in July, confounding analysts' expectations of a decline to 101.5.
Consumers were buoyed by better employment prospects, with the index of "jobs plentiful" rising to 23.5 percent from 22.9 percent and the measure of difficulty in finding work easing to 23.2 percent from 23.8.
That boded well for Friday's employment data, but did not change the bond market's view that the economy would inevitably take a hit from oil.
Five-year notes added 15/32 for a yield 3.98 percent, down from 4.08 percent. The 30-year bond gained 24/32 to yield 4.32 percent from 4.36 percent.
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