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US Treasury debt prices dropped rapidly on Thursday despite panicked selling in the stock market, as traders feared a looming swath of new government bond issuance would weigh on the market. Dealers worried the Treasury's $700 billion bailout package will be funded largely through more debt, putting pressure on historically low yields.
Such concerns were largely obscuring what would normally be a brutal, and bond-boosting, stock market plunge. On Thursday alone, the Dow Jones industrial average closed below 9,000 for the first time since June 2003. The S&P 500 is down nearly 40 percent from peaks hit last year. Benchmark 10-year notes dived 29/32 for a yield of 3.76 percent, up 10 basis points in just a day.
The gap between 2-year and 10-year notes grew from 209 basis points to 223, the widest in more than four years and a market signal of a rapidly cooling economy. "Supply is definitely a factor here," said David Coard, head of fixed-income sales and trading at Williams Capital Group in New York. The Treasury has auctioned a total of $40 billion on Wednesday and Thursday.
Bill rates did pull back a bit as the dumping of stocks accelerated toward the end of the trading session. Three-month bills were yielding a paltry 0.50 percent. Until recently, Treasuries had benefited strongly from the worsening credit crisis and associated downturn in economic activity.
The combination pushed benchmark yields, which move opposite to price, to their lowest in more than five years. But this week, the tide appeared to have turned because of a growing realisation that an increasing number of rescue packages will have to be funded somehow. This means a rather frantic debt auction schedule in the months ahead, and potentially a dose of inflation down the line - neither beneficial to bonds.
"This has be considered inflationary down the road," said Steve Point, lead portfolio manager at Glenmede Investment Management in Philadelphia. There was one caveat to the drop in bond prices: the economic situation is bad, and likely to get worse. Treasuries briefly pared losses after data showing yet another spike in continued jobless claims.
In an effort to stem this deteriorating outlook, the Federal Reserve on Wednesday slashed its benchmark rate by a half percentage point to 1.5 percent, as part of an unprecedented emergency move taken in co-ordination with other top central banks.
If conditions get sufficiently bad, traders say, it is not difficult to envision another pile-up into Treasuries. Indeed, investors are expecting a further decline in official interest rates. Fed fund futures on Thursday pointed to an 80 percent implied chance of a 25-basis-point cut at the Fed's next scheduled policy meeting on October 28-29.

Copyright Reuters, 2008

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