Bill-

A good view of the strange bond marketfrom our friend John Mauldin. Was it all a "tamer" CPI number? If so, it was quite a run-up. I tend to think options expiration day, as you suggested, had a bit to do with it. THe TLT has done this before in the past two months, only to slide south again. Article follows:

Core Inflation and Bond Market Prospects

In the past year, the price of crude oil ballooned 53% and the price for natural gas more than doubled, so the headline CPI inflation rate could soon exceed 4%. Yet, the more stable gauges of inflation have been flat in 2005. In the twelve months ended August, the core PCE deflator rose 2%, versus 2.2% for 2004. The figure for the market based core PCE was just 1.7%--identical to 2004.

Two of the persistent traits in the U.S. for more than a decade have been fast enhancement of worker productivity and cost containment in the corporate sector. Productivity in the nonfinancial sector - the only one where measurements are valid - bounded ahead at an unparalleled 6.4% in the past four quarters. Indeed, the 3.6% pace of the past five years is also without precedent, and considerably above the 2.1% long-term experience.

With labor compensation modest, unit labor costs inched forward a mere 0.4% in the past four quarters, beneath 0.7% in 2004 and a mean 0.8% per annum over the past five years. This suggests that wage push inflation is unlikely. Aided by global circumstances the Fed has done a very effective job of containing swollen energy prices.

The more subdued economic climate likely in 2006, plus continued Fed resolve, indicate that core inflation will move lower over the next year. With the tendency for long term Treasury bond yields to be determined by multi year patterns in inflation, Treasury bonds should continue on their long term path to lower yields.

And from my clever friends at GaveKal (www.GaveKal.com):

"On Friday, inflation was once again a hot topic. Indeed, US consumer price inflation rose to a 25-year high of +4.7% YoY in September (expected +4.3% YoY), a significant jump from last month's +3.7% YoY. Meanwhile, our P-Indicator has recently broken out of negative range, hinting at rising price pressures (see chart). So should we be worried about the potential return of inflation?

"We are not. In fact, looking at the latest US CPI number, we find that core consumer inflation (ex food and energy) actually slowed down to a tame +2.0 YoY (expected +2.1%). This compares with the annual core inflation of +2.3% in September of last year. So despite the strong rally of oil prices, it seems we do not have evidence of any second-round effects. As a side note, this point was also recently made by Australian Treasurer Peter Costello, when he stated, after the G20 meeting, that he did not believe the rising oil prices would lead to a significant increase of inflation.

"Another point to be made is that our diffusion index of US CPI is heading markedly lower. We realize that the average CPI is important, but we believe it is equally important to look at the net of sectors that can raise their prices minus the ones that have to cut their prices. So in our diffusion index of CPI components, we simply look at how many sectors (as reported by the statistical offices) have prices above their 12 months moving averages, and how many have prices below their twelve months moving averages. The difference is our diffusion index of the CPI components, and it is clearly weakening.

"As for the bond market, it doesn't appear to be overly worried about inflation either. Indeed, following the publication of the US CPI numbers on Friday, the benchmark 10-year Treasury note actually rose by 1/16 point, cutting the yield down to 4.45%, down from 4.46% before the report. Indeed, while yields have gained somewhat over the last weeks, they are still below their highs in late March, when the US consumer inflation rate was at +1.7% (vs. 4.7% in September) and oil prices were at US$54/barrel (vs. US$63/barrel today).

"One explanation could be that there remains a massive 'forced buyer' of bonds in the system, whether pension funds with unfunded liabilities, insurance companies preparing for 'Solvency II,' Japanese investors in search of yield, etc... If this is the case, then the message given by the bond market is not that significant. However, given the weakening core US inflation and the rising US$, we choose to not discount the message from the bond markets. In fact, we are very impressed by the bond market's resilience."