US Treasury debt prices rose for a third straight session and 10-year yields were pushed below two-year yields for the first time in five years possibly signalling US economic growth could slow in 2006.
Recent benign readings on inflation and signs of fraying in the housing market have dragged down longer-maturity yields recently, while expectations for at least one more Federal Reserve rate hike have held short-term rates steady.
The benchmark 10-year Treasury note jumped 10/32 in price for a yield of 4.343 percent, a two-month low, down from 4.378 percent on Friday.
Meanwhile, two-year note yields were at 4.351 percent, down from 4.364 percent, leaving the yield spread at an inverse of almost one basis point.
"The curve should be flattening if the Fed is assumed to be still tightening," said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi.
A roughly one percent drop in major US stock indices, also tied to worries that slower growth is on the cards, helped put a bid under bond prices as the day progressed. The Dow Jones industrial average shed more than 100 points.
An inverted yield curve has preceded the last four US recessions, although not every instance of an inverted curve has been followed by a recession.
"We believe that the two-year note has room to cheapen," said strategists at BNP Paribas. With 10-year note yields rangebound, "there is yet further flattening room in the curve," they said.
On Tuesday, a weak reading on the Richmond Fed's factory index was seen by some as a hint of what lies ahead in the national Institute for Supply Management manufacturing survey due on January 3.
The Richmond index fell to -2 in December from 9 in November, its first negative reading since July. New orders, order backlogs and employment were lower as well.
Still, doubts about US economic growth for 2006 are entwined mostly with prospects for the housing market.
Many economists look for home prices to flatten out, sales to slow and withdrawals of home equity to drop next year, ultimately pulling growth lower.
Weekly mortgage applications from the Mortgage Bankers Association are due at 7 am EST (1200 GMT) on Wednesday, followed by November existing home sales on Thursday.
Existing sales are recorded at closing and often reflect deals struck several weeks earlier. As a result, some dealers said a strong number on Thursday would likely be ignored.
Five-year Treasury notes rose 4/32 for a yield of 4.295 percent, down from 4.316 percent.
The 30-year Treasury bond rose 22/32 for a yield of 4.507 percent, down from 4.547 percent.
Trading volume was extremely thin, estimated by the interbank broker ICAP Plc. at about $102.5 billion or about 50 percent of normal levels. In rate futures, prospects for a March interest rate hike by the Federal Reserve slipped to 56 percent from 58 percent, and have stagnated in a tight range for weeks.
Dealers hope for better guidance on Fed policy from monthly employment report on January 6, and minutes from the Fed's December meeting, due on January 3.
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