US Treasury debt prices rose on Friday and benchmark yields sank to 10-month lows on data showing the US manufacturing sector contracted for the first time in 3-1/2 years in November.
Growing signs of weakness in the factory and construction sectors heightened market expectations the Federal Reserve could lower interest rates in early 2007 to stimulate economic growth, analysts and traders said.
"All the recent numbers are showing that the economy is slowing significantly. They are fuelling people's expectations that the Fed will cut sooner rather than later," said Andrew Richman, managing director of SunTrust's personal asset management division in West Palm Beach, Florida.
Two-year notes, which are most sensitive to changes in Fed policy, gained 5/32 in price for a yield of 4.53 percent, the lowest in 10 months, from 4.62 percent late on Thursday. Two-year yields shed more than 22 basis points this week, the largest one-week drop in 15 months.
The Institute for Supply Management said its index of national factory activity fell to 49.5 last month, below the growth point of 50. It was the first time factory activity has contracted since April, 2003.
This week, surprisingly soft data overshadowed the hawkish comments of Fed officials, including Chairman Ben Bernanke, and a relatively upbeat outlook in the Fed's Beige Book on regional economic conditions, investors said.
"The bond market is predicting that the economy is slowing more than what the Fed has been saying. The ISM has confirmed that," said Neil Wolfson, chief investment officer at Wilmington Trust in New York. US interest rate futures suggested that traders have priced in a strong likelihood that the Fed would begin paring official US rates by the end of the first quarter of 2007, versus a 50 or so percent chance a day earlier.
The weak ISM data followed a batch of unexpectedly weak regional business data on Thursday, lifting traders' hopes that the Fed would soon lower the federal funds rate, currently at 5.25 percent.
On Friday, two regional Fed presidents, Philadelphia's Charles Plosser and Chicago's Michael Moskow, said that while price pressures have been easing, the overall inflation level remained elevated and suggested that the Fed has left the door open to more rate increases.
"The market has moved beyond the Fed. We haven't seen any reactions on comments from Plosser and Moskow," said Wan-Chong Kung, senior portfolio manager at FAF Advisors in Minneapolis. Also supporting bond prices on Friday were data showing US construction spending fell by an unexpectedly large 1.0 percent in October.
The bond market could succumb to a technical pullback early next week ahead of the government's nonfarm payroll report, but the upward momentum is strong enough to overcome intermittent profit-taking and short-selling, investors and traders said.
"There's considerable momentum in the market. It seems that appetite to put money to work continues to be there," FAF's Kung said.
Benchmark 10-year Treasury notes kicked off December on a strong note, rising 6/32 in price. Their yields slipped to 4.43 percent from 4.46 percent late Thursday, after hitting a session low of 4.41 percent, a level not seen since late January.
Five-year notes rose 8/32 in price for a yield of 4.39 percent, off 6 basis points from late Thursday, and the 30-year bond climbed 7/32 for a yield of 4.55 percent, down 1 basis point from late Thursday.
Moreover, the inversion of the yield curve eased as the spread between the yield on two-year notes and 10-year notes shrank to 9 basis points, the smallest gap in nearly a month.
An inverted yield curve, in which shorter-dated bond yields are higher than those on longer-dated bonds, is regarded by some analysts as a harbinger of economic slowdown and possibly even recession.