Bonds up as sales data adds to Fed cut expectations

By Chris Reese

NEW YORK (Reuters) - Treasury debt prices rose on Friday after data showing unexpectedly weak consumer spending in July and August added to expectations that the economy is tipping into recession.

Bonds showed more strength on the short end, which is particularly susceptible to Federal Reserve interest rate expectations, as investors upped forecasts that the next move from the central bank would be a rate cut.

The government said total sales at U.S. retailers in August fell 0.3 percent after a sharply revised 0.5 percent drop in July that previously was reported as only a 0.1 percent decline. Wall Street analysts surveyed by Reuters had expected a 0.2 percent sales increase in August.

"It pretty much sounds the death knell for the consumer here," said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ in New York, adding "the consumer could be the one factor that tips the economy into recession."

Benchmark 10-year Treasury notes were trading 2/32 higher in price for a yield of 3.64 percent from 3.65 percent late on Thursday, while 2-year notes US2YT=RR were 3/32 higher for a yield of 2.18 percent from 2.23 percent.

U.S. short-term interest rate futures boosted the implied chances of a Fed rate cut before year-end to 36 percent from 28 percent late on Thursday.

That marks somewhat of a sea change from about two months ago, when investors were betting the Fed would have to raise rates in the near term to fight inflation. Falling commodity and energy prices in the meantime have turned that outlook around.

Indeed there were more signs of easing price pressure, at least on the wholesale side, on Friday.

The government said U.S. August wholesale prices dropped by a bigger-than-expected 0.9 percent, the sharpest retreat in almost two years. Meanwhile, core prices, which strip out food and energy costs, rose 0.2 percent as expected after a 0.7 percent surge in July that had fanned inflation fears.

But with the sales and inflation data out of the way on Friday, investors returned their focus to the state of U.S. financial companies and speculation on the future of investment bank Lehman Brothers LEH.N.

Lehman stock has plunged on disappointment over the company's inability to work out a deal to bolster its capital needs, and fostered speculation that some kind of bailout plan will be needed in order for the company to survive.

"Everybody is just keying off Lehman and the musings there and what may occur or not occur over the weekend," says Marty Mitchell, head of government bond trading at Stifel Nicolaus & Co. in Baltimore.

Five-year Treasury notes were trading 7/32 higher in price for a yield of 2.88 percent from 2.93 percent late on Thursday, while 30-year bonds were 2/32 higher in price for a yield of 4.22 percent.

(Additional reporting by John Parry; Editing by Andrea Ricci)