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Bond market sees more rate cuts ahead

January 23, 2008 | "Associated Press"

Federal Reserve slashes key interest rate to 3.5%, but price spike in the 2-year signals an expectation of further Fed action.

Short-term Treasurys rallied sharply, sending a signal that investors expect further rate cuts, after the Federal Reserve on Tuesday reduced the overnight bank lending rate to 3.5 percent.

The rate cut of 0.75 percent followed massive selloffs on global stock exchanges Monday. The market routs reflected growing consensus that the U.S. economy was on the brink of recession and could lead to weaker performance elsewhere.
Tuesday's unexpected announcement came one week before the committee's regularly scheduled policy meeting.

"The Fed has cut the funds and discount rates by 0.75 percentage point, citing the weakening economic outlook ... the deterioration in the markets and tighter credit conditions," said Ian Shepherdson, chief U.S. economist at High Frequency Economics. "But there can be little doubt the Fed would have waited until the meeting next week if it had not been for the state of the markets."

After the Fed action, stock markets improved in Europe. Wall Street posted massive losses in early trading, but those losses lightened considerably as the day wore on.

Treasurys had a more complex reaction. Initially, investors sought to push short-term rates lower by buying them and longer-term rates higher through selling them, a strategy intended to widen the difference between their yields. This sort of trade is known as a "yield steepener."

However, prices for all maturities were higher by the end of the session, although demand was strongest for 2-year notes.

The heavy purchasing of 2-year notes, which are the most sensitive to rate developments, drove their yield well below the new Federal funds target. This is notable because, as a general rule, the 2-year yield trades within 0.25 percentage point of the Fed funds target. But at Tuesday's close there was a sizable 1.44 percentage point difference.

The sharp losses for the 2-year yield are a classic sign that investors expect further declines in the Federal funds target - a tactic that puts pressure on the Fed to cut further.

"The bond market is screaming to the Fed to get the Fed funds rate down further," said Donald Selkin, director of equity research at Joseph Stevens.

The 2-year note rose 11/32 to 102 8/32 with a yield of 2.06 percent, down sharply from 2.35 percent late Friday. Prices and yields move in opposite directions.

The 10-year note advanced 9/32 to 106 10/32 with a yield of 3.49 percent, down from 3.63 percent late Friday.

The 30-year bond gained 9/32 to 112 28/32 with a yield of 4.23 percent, down from 4.28 percent late Friday.

More purchasing in after-hours trade sent yields even lower. At 5:30 p.m. EST, the 2-year yield was 1.99 percent, the 10-year yield was 3.41 percent and the 30-year yield was 4.20 percent.

The yield on the 3-month note fell to 2.32 percent from 2.85 percent on Friday as the discount rate dropped to 2.27 percent from 2.79 percent.

Many market players expect the Fed to cut rates once more at its meeting on Jan. 29-30.

Will the cure be worse than the disease?

The reference in the Fed statement to "appreciable down side risks to growth" is a clue that the Fed is likely to put in place a 0.50 percentage point rate reduction next week, according to Bernard Baumohl, managing director of the Economic Outlook Group.

"Yet even this may not be enough to calm worries in the global financial markets," Baumohl said. Global investors may pressure the European Central Bank and others for rate reductions, even though some economists had questioned whether the euro zone and other economies are as strongly linked to the U.S. as they once were.

Although bond investors cheered the Fed's action, lower rates also are a sign that policymakers are bracing for recession. On Tuesday, Merrill Lynch chief North American economist David Rosenberg forecast there will be a recession through the end of the third quarter. UBS also issued research foreseeing a recession - although one of less than average severity.

Despite the continuing worries about the severity of the global credit crisis and an overall slowdown, Tuesday's news brought about some positive developments for consumers and commercial borrowers.

For instance, many major U.S. banks cut the prime rates they charge on loans to their most creditworthy customers by 0.75 percentage point, in line with the Fed's action.

And the lower prime rates will reduce the debt payments for many strained businesses, according to Tony Crescenzi, fixed-income analyst at Miller Tabak.
In addition, rates on many contracts for London Interbank Offered Rates, or LIBOR, fell on Tuesday. Lower LIBOR rates should spell relief for some American homeowners, as many U.S. mortgage rates are tied to LIBOR.

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