U.S. Bond Rally Could Falter Next Week Unless the Fed Cuts Interest Rates
Bond Investors Bank on Fed Rate Cut: Rates of Return (Update1) (Adds details on the week's trading activity in 6th paragraph.)
New York, Sept. 11 (Bloomberg) -- The rally that drove long- term bond yields to record lows this week could reverse course unless the Federal Reserve cuts interest rates by at least half a percentage point by the end of the year, investors said.
Yields on Treasuries of all maturities are below the Fed's 5.5 percent target for overnight loans between banks, the first time that's happened since 1990. Unless the Fed lowers rates the rally that handed 30-year bond investors returns of about 13 percent since April could come to a screeching halt.
Some investors expect the Fed to make a half-point cut on Sept. 29, when policy-makers next meet. They say the Fed needs to lower rates to help quell financial turmoil overseas and buttress U.S. economic growth.
If Fed officials do that, ''They will have effectively confirmed what the market has done,'' said Closson Vaughan, who oversees $2.5 billion at Columbia Partners LLC in Washington. ''If the Fed eases only 25 basis points and says it's only an insurance-policy-type step, two-year notes are going to get killed,'' Vaughan said.
Two-year notes, among the most sensitive to Fed rate policy, now yield 4.69 percent, the lowest since early 1994. That's 81 basis points below the Fed's target rate for federal funds. Over the past year, two-year yields have averaged only 3 basis points below fed funds.
Bonds today fell for the first time in three days, as stocks rose and as investors balked at the low yields. Even so, the 30- year yield fell 6 basis points on the week to 5.23 percent. 'Dangerous' Territory ''It's dangerous in here,'' given how low yields have fallen, said Jim Somers, who manages $2.5 billion at Martindale Andres & Co. in West Conshohocken, Pennsylvania. ''The Fed has got to ease probably 100 basis points to support the levels we're at right now -- at least.''
Forecasts for a rate reduction heated up since Sept. 4, when Fed Chairman Alan Greenspan said U.S. economic growth will probably slow because of recent declines in global markets. ''It's just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress,'' the Fed Chairman said.
Investors took his remarks as a hint the Fed will lower rates if the financial crises in Asia and emerging markets worsen. It last changed its target for the federal funds rate in March 1997, raising it a quarter point.
Futures on Eurodollars, or dollars on deposit outside the U.S., suggest that rate-cut expectations are growing. The March contract for three-month Eurodollars has an implied yield of 4.97 percent, 53 basis points below the current rate on three-month borrowing. That's a sign traders are betting the central bank will lower rates by a half point before the contract expires in mid-March.
Go Slow Approach
Christopher Rupkey, an economist at Bank of Tokyo- Mitsubishi, said he doesn't expect the Fed will reduce rates that much, though he's calling for a 25-basis-point cut on Sept. 29. ''The Fed doesn't cut rates aggressively unless U.S. citizens are being laid off, and that isn't happening,'' he said.
Others agree that the strength of the U.S. economy may deter the Fed from cutting rates as much as some investors anticipate. The unemployment rate, at 4.5 percent in August, is near the lowest in almost three decades, while low mortgage rates are fueling a boom in the housing market. As recently as its July meeting, the Fed indicated it was more likely to raise than lower interest rates.
Without a cut of at least 50 basis points, the cost of borrowing money to buy bonds -- a common practice among big traders -- is getting more expensive. It now costs more to borrow than traders earn from the yields on the securities themselves.
So far that hasn't been much of a concern. Profits from the rush into government securities by investors looking for a refuge from global financial turmoil have more than made up for the added cost. Yet if demand for Treasuries as a haven from selling in other markets wanes, the pain that comes from holding securities that return less than it costs to finance them could prompt selling, some traders said. 'Scary Market'
Meantime, analysts say bond yields probably won't fall as much as short-term yields even if the Fed does cut. That's because investors in short-term securities such as two-year notes aren't worried that inflation could rise over the next few years. For 30-year holders, though, there's a chance a series of rate reductions now could spur inflation and hurt their returns.
A rate cut ''would be unambiguously good for the short to intermediate part of the market. For the long end, it's a little less clear,'' said Hugh Whelan, who manages some $6 billion at Aeltus Investment Management in Hartford, Connecticut.
William Dawson, who oversees about $76 billion in bonds at Federated Investors in Pittsburgh, said he can't see bond yields falling much further without signs that the economy is slowing. Thirty-year rates, now at 5.22 percent, are near the lowest since the U.S. started regular sales of the securities in 1977. ''It's a scary market,'' said Alan Day, who helps manage $2.1 billion at Stratevest Group in Burlington, Vermont. ''You can really get burned in a market like this if it sells off.''
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