Bernanke boosts short-term bonds

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NEW YORK (CNNMoney.com) -- Short-term bond prices rallied Tuesday, but long-term bonds fell after Federal Reserve Chairman Ben Bernanke gave a grim economic outlook.

The benchmark 10-year note rose 3/32 to 100 7/32 and yielded 3.84%, down from 3.88% late Monday. Bond prices and yields move in opposite directions.

The 2-year note gained 4/32 to 100 29/32, and its yield slid to 2.39% from 2.48% late Monday.

But long-term Treasurys sank, as Bernanke hinted that a rate hike to stem the tide of inflation may not be justified anytime soon in the rough economic climate. The 30-year long bond fell 15/32 to 98 10/32; its yield rose to 4.47% from 4.45% in the previous session.

In a hearing before the Senate Banking Committee early Tuesday, Bernanke said multiple factors are dragging down the U.S. economy. (Full story).

"The economy continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil, food and some other commodities," Bernanke told the committee.

When economic times are tough, investors tend to buy up government bonds, which are generally believed to be less risky investments than stocks.

"After Bernanke, we're seeing stocks struggling, turmoil continues in the wake of Fannie Mae and Freddie Mac, and financials remain weak," said Scott Anderson, senior economist with Wells Fargo. "Investors are looking for the perceived safe haven of the bond market."

Also supporting bond prices Tuesday was a drastic drop in oil prices. Crude futures plummeted by as much as $9 a barrel, before recovering a few dollars, as investor fear that the nation's financial woes could cut into demand deepened. (Full story).

"When oil falls, that helps on the inflation fears front," said Anderson.

Rising commodity prices - especially record oil prices - have pinched the pockets of Americans, resulting in a devalued dollar. Bond investors are typically wary of high inflation, because a declining dollar has the potential to negate the interest they earn on their investment.

For the long term, however, Bernanke expressed concerns about rising inflation risks stemming from high commodity prices, suggesting that the Fed might not be able to take steps to support economic growth because of those risks.

The Fed has historically raised interest rates to stem the tide of inflation, but Bernanke suggested the poor economic conditions may not support a decision to hike rates in the near future.

"Bernanke took out the phrase, 'Downside risk to growth had been diminished,' which puts the Fed firmer on the fence for a rate hike," said Anderson. "As a result, bonds will dance around the current range, but won't move much higher for the time being."