News about a planned U.S. stimulus package helped pull investors into the dollar on Monday but U.S. Treasury prices slumped on fears a price bubble is about to pop in the face of a massive wave of fresh debt.

European equities advanced for the fifth session in a row, spurred by gains in shares of oil companies on the back of rising crude prices. U.S. stocks were mostly lower as investors took profits on the rally that was racked up in thin trading last week.

Oil prices hit a three-week high as Israel’s deepening incursion into Gaza and a Russian gas dispute heightened fears about supplies.

Prospects for a swelling supply of government debt drove U.S. and euro-zone prices down. The U.S. Treasury said it would sell $16 billion of reopened 10-year notes and $30 billion in three-year notes this week.

While the issuance was broadly in line with market forecasts, it underscored this year’s looming surge of debt that will to fund government efforts to rescue the financial system.

U.S. President-elect Barack Obama plans $310 billion in tax cuts as part of a rescue package of up to $775 billion, senior Democratic aides said Sunday. German Chancellor Angela Merkel met her Social Democrat (SPD) coalition partners to discuss a second fiscal stimulus deal worth up to 50 billion euros ($68 billion).

The 30-year Treasury bond fell nearly three full points in price, pushing its yield up to 2.92 percent, up from a record low near 2.52 percent in December.

“The back-up in yields shows a growing sentiment toward questioning the lower rate environment we are in right now,” said George Goncalves, chief Treasury/TIPS and agency strategist with Morgan Stanley in New York.

The euro hit three-week lows versus the dollar, with weaker-than-expected Italian and Spanish inflation data and tax cuts in Germany expected to pressure the European Central Bank to soon cut rates further.

U.S. stocks fell as investors took profits following last week’s sharp gains.

“Right now we’re just watching and waiting to see if there is any news from the new administration and what type of news it will be,” said Frank Lesh, a futures analyst and broker at FuturePath Trading LLC in Chicago. “We got a little bit of profit taking here,” he added.

Shares of Apple Inc rose after chief executive Steve Jobs wrote a letter aimed at dispelling investor concerns about his recent weight loss. Shares of the iPod maker rose 4.4 percent to $94.75 in early afternoon trade.

Before 1 p.m., the Dow Jones industrial average was down 79.09 points, or 0.88 percent, at 8,955.60. The Standard & Poor’s 500 Index was down 3.27 points, or 0.35 percent, at 928.53. The Nasdaq Composite Index was down 8.52 points, or 0.52 percent, at 1,623.69.

European equity markets were buoyed by the anticipation of further fiscal stimulus, drawing flows away from the safer-haven of government bonds.

The FTSEurofirst 300 index of top European shares ended 1.9 percent higher at 873.01 points.

The telecommunications sector was one of the biggest gainers on the index on the first full day of 2009 trading for many, with Swisscom (SCMWY) rising 5.2 percent, Cable and Wireless adding 4.6 percent, Vodafone (VOD) up 4.3 percent and Portugal Telecom (PT) rising 4.6 percent.

Sharp losses for the euro, which was down 2.28 percent at $1.3559, also spread to euro/sterling, taking it to 0.9278, well away from record lows for the pound last week and easing momentum towards parity.

The dollar rose against a basket of major trading-partner currencies, with the U.S. Dollar Index up 1.74 percent at 82.923. Against the yen, the dollar rose 1.31 percent at 93.43 from a previous session close of 92.220.

Longer maturity government debt fell, but shorter-term debt was little changed to higher. The benchmark 10-year U.S. Treasury note fell 34/32 in price to yield 2.47 percent, and the 30-year U.S. Treasury bond fell 102/32 in price to yield 2.94 percent.

Oil rose, and has gained more than 35 percent since Israel launched its attack on Gaza on Dec. 27, increasing concerns about the supply of crude from the Middle East.

U.S. light sweet crude oil rose $1.11 to $47.45 a barrel.

U.S. gold futures dropped, breaking below $850 an ounce, as investors took profits on the back of a dollar rally and signs of slowing physical demand.

Spot gold prices fell $22.45 to $852.60 an ounce.

Asian stocks rose to a two-month high on hopes massive government spending programs will revive a global economic recovery later this year.

The MSCI index of Asia-Pacific stocks outside Japan climbed 1.6 percent to a two-month peak, while Japan’s Nikkei average gained 2.1 percent in a shortened session to reach a two-month high.

NEW YORK, Jan 5 (Reuters)

But while Treasury prices hit record highs, concerns surfaced among analysts about how much farther the rally can go considering the implied message in the Fed’s statement that the economy is in worse shape than we thought and policy makers will do anything they can to keep it from completely tanking.

“Everyone originally was very enthused yesterday because the Fed made it known they were going to stand and do anything that is necessary, no matter what, to get this economy back on track,” said Sal Arnuk, co-manager of trading at Themis Trading in Chatham, New Jersey. “This morning we awaken with a hangover and the realization of how many bullets do they have left?”

Long term Treasuries with 10- and 30-year maturities were favored by investors after the Fed said it would keep long-term interest rates suppressed for “some time.”  In its statement the central bank vowed to buy agency and mortgage-backed securities and said it will consider purchasing government debt.

Yields on the 10- and 30-year notes tumbled in New York trading, touching their all time lows, according to BGCantor Market Data, as investors continued to bid up prices.

And for the second straight day, investors in the shortest government securities were willing to accept a negative return for the safety of U.S. government debt, as yields on one-month T-bills reached minus 0.02%.

But the Fed’s latest statement has raised doubts about its real intentions with some analysts.  Even though the central bank promised to purchase treasuries to keep interest rates from rising, policy makers will likely avoid purchasing government debt, according to RDQ Economics LLC.

“This step is still an unlikely one for the Fed to take, since it is trying to narrow the spread between mortgage-backed securities and Treasuries,” John Ryding and Conrad DeQuadros, founders of New York-based RDQ, wrote in a note yesterday.

30-year mortgage bonds issued by Fannie Mae (FNM) currently yield 1.49 percentage points more than the benchmark 10-year Treasury note, down from 1.62 percentage points Tuesday. The Fed wants to drive those yields down to encourage borrowers and lenders.

More skepticism comes from the rates themselves.  After all, how many investors can tolerate a negative return on their money, when the very nature of investing says they will eventually demand a respectable return?

History is another factor leading some investors to conclude that the Treasury rally is overdone because yields simply can’t fall much further.  For instance, the 10-year Treasury currently yields around 2.5%, despite an average of 6.91% since 1962.

Then there are those who see the Fed’s move to cut rates to virtually zero as validation of the market’s valuation of short-term credit.  Treasury markets had already breached the Fed’s previous Federal Funds target of 1% before Tuesday’s move to cut that target to 0% to 0.25%

“Short-term interest rates have been falling sharply since the financial markets went into a tailspin in September. With Tuesday’s announcement the Fed was essentially acknowledging that it can’t control interest rates any more,” said John Schoen a Senior Producer at MSNBC.

That may be speculation, but the Fed was indeed conspicuous by its absence in the open markets early Wednesday.

According to Reuters, the Federal Reserve of New York said the U.S. central bank had refrained from any open market operations on Wednesday. Typically the New York Fed conducts open market operations at 9:30 a.m.

The regional Fed conducts open market operations for the central bank system. The Fed normally supports its monetary policy by executing short-term purchase and reverse repurchase agreements to influence day-to-day trading in the Federal Funds market.

Federal funds, the benchmark overnight lending rate to banks, last traded at 0.0625%, within the Fed’s new target range of zero to 0.25%.
Source: Fed’s Zero Interest Policy Fuels Treasury Rally