Next Thursday is first strike date for over $ 480 B in Y2K overnight loans
US TSY OUTLOOK: BEARS TO RULE IN THIN TRADING; FOMC FOCUS
By Ellen Taylor
NEW YORK (MktNews) - Trading in U.S. Treasuries will remain volatile next week with a bearish bias, as dealers will be cautious ahead of Tuesday's FOMC meeting, traders said.
If the bond market didn't have enough liquidity problems to cope with already with so many players closing books early ahead of potential Y2K disruptions, trading will be shortened by the early 2 p.m. EST close Thursday and day off on Christmas Eve Friday.
The market's major worry next week will be what the Fed does, or doesn't, say about monetary policy. "We could see a change in the Fed's bias Tuesday, which would have more of a psychological impact than anything else," said George Adell, in charge of arbitrage trading for Starboard Capital Markets. "But then psychology moves markets."
Though no one expects the FOMC to rock the markets by increasing interest rates so close to Y2K, talk has been rampant for weeks that policymakers will conclude they are more inclined to raise, than lower, interest rates in the future.
Such a nuance is known currently as a "tightening bias", though the meeting is also expected to produce a public definition of what a bias actually is. The misunderstanding of this illusive concept has added volatility to the market this year.
"What the Fed might say is, 'No, a tighter bias doesn't necessarily mean we will tighten in February'," said Chris Rupkey, senior financial analyst at Bank of Tokyo/Mitsubishi.
Strategists said that current market negativism has not only already built in a firmer Fed bias but also a rate hike to reflect a 5 3/4% funds target by early February, as seen in rates on Federal funds futures contracts as well as in when-issued yields on the December 2-year note that will be auctioned Tuesday.
Still, in this enormously illiquid, pre-holiday market next week, prices could get beaten down more if the Fed validates the market's expectation.
"If the Fed puts on a firmer bias, you could see a quick downtrade, then a modest recovery, on the news," said Gemma Wright, a senior interest-rate strategist for Aubrey G. Lanston. "But thin market conditions will persist and a lot of people will want to be even ahead of year end" ten days after the Fed meeting.
And while price action this week suggests the bond market is fearing the worst Tuesday, many strategists still argue the Fed won't change either its bias or rates Tuesday. They contend policymakers won't want to roil the markets so close to the Y2K-related liquidity problems expected during the week between the Christmas and New Year's holidays.
Many traders and customers won't even be in offices to support price action next week ahead of the long Christmas weekend. That is likely to further exaggerate price movements, causing already sharply diminished liquidity to shrink even more, analysts said.
"We are seeing no retail this week. None," said another market analyst Wednesday. "What buying we do see is only shortcovering when the market dips."
With the 30-year bond yield already hovering at 6.384%, just beneath its 1999 high of 6.40% set on Oct. 25, traders said it's more likely the bond will break out to a 6.50% yield before year end than to rally to 6.25% again.
"You could see the bond go to 6.50% just ahead of the FOMC," said Rupkey.
On Wednesday the market will have to bid on $15 billion in Dec. 2-year notes in the absence of takers. The notes must be paid for on the worst possible financing day of the year, on Dec. 31. But there could also be Y2K-related quality preferences sparking demand for the note, some trader said.
"The 5 7/8% November 2-year note was trading a little special on repos today so there seem to be sizable shorts set up in the 2-year sector," said Lanston's Wright.
The final report on third-quarter U.S. GDP will be released Wednesday as well. The first estimate indicated strong growth of 5.5%, more than double the second quarter's 1.9% expansion and analysts don't expect much of a change in the update report.
Reports on personal income and spending last month are also not expected to impact price action, analysts said. They will also be released Wednesday.
Analysts expect an increase in November durable goods orders and initial unemployment claims for the week on Thursday, but said both will likely be dismissed as rebounds of the previous reports.
On Thursday, the Fed will release the minutes from its Nov. 16 meeting at which it raised the funds target to 5.50%, so it's likely to be seen as anticlimactic. Coming two days after the Dec. FOMC meeting, new trading ranges will have already been established and will likely persist over the last week of 1999.
Finally, Thursday also marks the first strike date for the total of $481B in options on overnight repos sold by the Fed this fall to give dealers emergency "as needed" financing over the Y2K turn.
Few traders expect dealers to exercise any of those options before or on Dec. 23 since financing problems will not surface until a week later when rates are more likely to come under extreme upward pressure over New Year's weekend. Since the strike price is set 150bps above the funds target, funds would have to be trading at 7% or higher Thursday to put the options "in the money." |
