The Federal Reserve’s dramatic 75 basis point cut in the federal funds rate target yesterday sent Treasury and municipal yields lower, and left participants uncertain about future Fed monetary policy action.
The cut, which brought the target rate to 3.50% from 4.25%, marked the first monetary policy action taken by the Federal Open Market Committee between scheduled meetings since Sept. 17, 2001, the first trading day after the Sept. 11 terrorist attacks. It also marked the first 75 basis point lowering of the rate in more than 23 years, since October 1984.
While the municipal market firmed by as much as 15 basis points on the short end and up to three basis points in the longest maturities, trading activity was situated mostly in bonds maturing within 10 years.
“It’s a market that appears to be going in two directions at the same time,” a trader in Los Angeles said. “The short end certainly has had a tremendous rally, and the longer end is feeling better, but there doesn’t seem to be any real conviction. Pre-refunded bonds are ruling the day, which only makes sense. Anything with insurance on it is being viewed rather skeptically, and as a consequence, people are waiting to see what’s really going to happen. There seems to be a little more conviction on the shorter end, as long as it’s got some kind of underlying credit.”
Traders said that bonds traded between 10 and 15 basis points firmer within five years, between eight and 10 basis points firmer from six to 10 years, from four to six basis points firmer from 11 to 15 years, and anywhere from one to three basis points firmer, in light trading, along the rest of the scale.
“The long end is obviously firm, but I’m just not seeing any business. I think a lot of people just don’t know what to do,” a trader in New York said. “There’s some bid-wanteds, but that’s about it. Marked offerings, but nobody pursuing them. It’s just like a lot of noise, but no fire at all. I hit a bid on a block of bonds I own, but other than that, I haven’t sold a damn thing.”
According to its statement, the Fed “took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in the short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.”
Jim O’Sullivan, senior economist at UBS Securities LLC, said the monetary policy action yesterday has lessened the risk of a recession.
“It certainly helps. The more they stimulate, the less weakness we’ll ultimately have. Now, whether it’s enough at this point to prevent a recession is debatable,” O’Sullivan said. “In fact, we did change our call [yesterday morning] at 7:00 [Eastern Standard Time] to look for recession in the U.S. this year, but certainly the more they ease, the better the chance the economy will be recovering by the second half of the year. It’s totally a good move, but again, it may well be where it kind of limits the degree of weakness rather than prevents a recession, per se.”
In response to the move, Treasuries showed sizeable gains, especially on the short end. The benchmark 10-year Treasury note, which opened at 3.63%, finished at 3.49%. The yield on the two-year note, was quoted near the end of the session at 2.06%, after opening at 2.35%. The yield on the 30-year Treasury bond, which opened at 4.11%, finished at 4.20%.
“The whole curve is up. This is a complete flight-to-quality, but the yield curve is reshaping a little bit,” said Bill Hornbarger, chief fixed-income strategist at A.G. Edwards & Sons. “The long end is off the highs seen before the rate cut, but the two-year has seen some more gains after the rate cut.”
Hornbarger said he expects the Fed to bring the rate down to 3%, or possibly lower, by the end of the year.
“I don’t know if we’re going to get another cut at the end of the month, though,” he said. “I think it’s kind of contingent on how the markets act. I think we’ll get another one at one of the next couple of meetings, but I’m not sure it’s going to be next week. I think if the markets settle down, they might hold off.”
O’Sullivan, on the other hand, is expecting another cut, this one of 50 basis points, when the FOMC meets on Jan. 29 and 30.
“More than likely, they will cut again; otherwise it increases the chance that they’d have to come in between meetings,” O’Sullivan said. “The meeting after next week is March 18, so we’re looking for another 50 basis points next week, and in total, we’re looking for them to go to 2.25% by the third quarter.”
Following the Treasury rally, there has been much tax-exempt follow-through, according to trades reported by the Municipal Securities Rulemaking Board, though much of it has come on the short end of the curve.
Bonds from an interdealer trade of insured West Virginia School Building Authority 5s of 2009 yielded 2.60%, 20 basis points lower than where it was traded Friday. A dealer sold to a customer insured Oklahoma Capital Improvement Authority 5s of 2010 at 2.72%, down seven basis points from where it was sold Friday. A dealer sold to a customer Greensboro, N.C., 5s of 2016 at 3.00%, 13 basis points lower than where it traded Friday.
Bonds from an interdealer trade of Washington’s Central Puget Regional Transit Authority 5s of 2036 yielded 4.25%, down two basis points from where they were sold Friday. Bonds from an interdealer trade of California 5s of 2037 yielded 4.70%, down one basis point from where they traded Friday. Bonds from an interdealer trade of Pennsylvania Housing Finance Agency 4.7s of 2037 yielded 5.06%, one basis point lower than where they were sold Friday.
“I haven’t had much luck once you get beyond 15 years,” a second trader in New York said. “But it’s definitely moving up, obviously with the meltdown of stocks and bond market pretty much. The real problem I’m noticing is that the buyers just aren’t jumping in that quick. There are so many problems with the underlying bonds too. With all the insurance downgrades, it’s hard to find what they’re looking for, or it’s not there. It doesn’t necessarily mean because the market’s up that you can sell anything.”
Evan Rourke, portfolio manager at MD Sass, said he thinks people in the municipal market are still trying to adjust to the news, as they have a lot to process.
“Absolute values are starting to be a little bit of a turn-off,” he said. “Are you going to lose individual investors at these levels? I don’t think leveraged accounts are going to be heavily involved, because there’s too much going on in terms of people trying to tighten up their balance sheets. I don’t think they want to have that much exposure in leveraging up here, though on a relative basis you can get some very high percentages. There’s potentially some interesting trades there, but you have to be able to weather some of this volatility.”
“The motive right now is safety,” Rourke said. “So you take leveraged players out of it, you may have trouble with individual investors on the absolute level of yields, and that leaves you with your traditional institutional investors, like insurance companies and mutual funds. I think there’s still some cash in our market, but again, the volatility makes it difficult interpreting what’s going on with the bond insurers, and how they’ll impact the market. I think there’s a lot to process right now.
The Fed’s statement added that the FOMC “expects inflation to moderate” in the near term, “but it will be necessary to continue to monitor inflation developments carefully.”