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Muted Inflation Data Provides Further Boost to Government Bonds

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06/12/2019 | 05:01pm EDT

By Sam Goldfarb

Yields on short-term U.S. government bonds fell Wednesday after another set of tame inflation data bolstered investors' expectations that the Federal Reserve will soon move to cut interest rates.

The yield on the two-year U.S. Treasury note, which is particularly sensitive to changes in monetary policy, settled at 1.891%, compared with 1.922% Tuesday. The yield on the 10-year note also slipped, falling to 2.129% from 2.140%.

Yields, which fall when bond prices rise, declined after the Labor Department said consumer prices excluding volatile food and energy products rose 0.1% in May from the previous month.

That was below the 0.2% increase anticipated by economists surveyed by The Wall Street Journal and the latest sign that inflation is failing to catch momentum despite a strong labor market and growing economy.

Inflation is a major threat to government bonds because it erodes the purchasing power of their fixed payments. In theory, muted inflation on its own should provide a bigger boost to longer-term debt than short-term bonds. Recently, though, investors have been more focused on the possibility that it could push the Fed to lower rates -- something that typically has a greater impact on short-term Treasurys.

Federal-funds futures, which investors use to bet on the direction of interest rates, suggested Wednesday that traders think there is a 23% chance that the Fed will cut rates at its meeting next week, according to CME Group data, up from 17% Tuesday. They also indicated an 83% chance of a rate cut by the end of the Fed's July meeting.

Investors are starting to believe "we're really never going to get inflation," said Wen Lu, U.S. rates and derivatives strategist at TD Securities in New York.

Soft inflation, coupled with concerns about the global growth outlook, have generally boosted Treasurys in recent months, causing the 10-year to fall from the roughly 2.6% level it reached in mid-April. Even with yields around their lowest levels since 2017, demand was solid Wednesday for a $24 billion 10-year note auction, analysts said.

Given growth fears, yields on corporate bonds haven't fallen as quickly as those on Treasurys.

Still, the average extra yield, or spread, that investors demand to hold U.S. investment-grade corporate bonds over Treasurys has edged down in recent days to 1.24 percentage points as of Tuesday, from 1.30 percentage points on June 3, according to Bloomberg Barclays data. The average spread on speculative-grade corporate bonds has also fallen to 3.89 percentage points from 4.43 percentage points over that span.

The WSJ Dollar Index, which measures the U.S. currency against a basket of 16 others, was up 0.3% in midafternoon trading at 90.35 .

Write to Sam Goldfarb at sam.goldfarb@wsj.com

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