Munis Weaken as Fed Slashes Funds Rate

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The municipal market weakened yesterday amid a sprinkling of new issues, as participants dealt with news that the Federal Reserve slashed the federal funds rate target 50 basis points to 1.50%, in a coordinated move with other central banks.

Traders said tax-exempt yields were weaker by three to five basis points.

"There's some weakness out there for sure, but no one really knows what to do at this point," a trader in Los Angeles said. "There's so many moving parts to this that a lot of people are still on the sidelines, waiting to see how this all plays out. It's hard to figure anything out in this market these days."

In the new-issue market yesterday, Massachusetts finally priced its $750 million revenue anticipation note sale, which was first postponed last Wednesday, and was then again put on the shelf Tuesday. The deal was originally expected to sell competitively, but a negotiated pricing with co-managers Citi and Goldman, Sachs & Co. was completed yesterday.

"I am very pleased that the commonwealth is leading the re-opening of the municipal markets," said state Treasurer Tim Cahill. "I hope this signals that the markets will continue to improve. This sale, and its postponement, received a lot of attention over the last few days. [Yesterday's] results show that investors still see the commonwealth as a very strong credit, and it underscores that the commonwealth will enter the market only when it is confident that it will receive strong pricing."

The emergency interest rate cut came three weeks before the next scheduled Federal Open Market Committee meeting and one day after Fed chairman Ben Bernanke alluded to the possibility of a rate cut in a speech.

In the accompanying statement, the Fed wrote that "incoming economic data suggest that the pace of economic activity has slowed markedly in recent months."

The cut was the eighth since September 2007, and the second to come in between regularly scheduled meetings since then. The FOMC left rates unchanged at the previous three meetings.

Jim O'Sullivan, senior economist at UBS, sees more Fed easing on the horizon.

"Certainly, they're not going to stop at 1.5%. I think lower interest rates will help, but the question is what more can be done?" he said. "Obviously, there's the big bailout package as well, but will they have to come back and do even more to directly help the banking system. But certainly, as far as the Fed goes, there is pressure on them to do more."

However, O'Sullivan doesn't see any additional rate cuts taking place until the FOMC's next meeting, which is a two-day session scheduled to conclude Oct. 29.

"I think there's a limit to what they can do in between meetings. There's only so much a rate cut can do," he said. "They've made their statement and they'll come back to the meeting and likely cut again. And there may be other liquidity measures that the Fed can take. They keep coming out with things, like including the commercial paper facility [Tuesday]. Whether there's something more they can do with the Libor market, I don't know. But they'll just keep on adding. Certainly, the Fed's balance sheet is going to continue to grow dramatically."

O'Sullivan also said that, while the Fed won't take the rate down to zero, they could quite possibly dip below 1%.

"Maybe a little below. They're not going to go to zero. I think it's pretty clear from the last cycle that they don't want to go all the way to zero, because of the implications for the money market fund industry. It would probably destroy that industry," O'Sullivan said. "So they can't do what Japan did, in that sense. But there's still a lot they can do.

"Even if they only go to 1%, if they start committing that they are going to stay at 1% for a long period, then that also is quite stimulative, because that starts moving the 1% level out the yield curve," he said. "In principle, even if you had 1% on the funds rate and long-term interest rates over 3%, if you keep on extending out your commitment on the yield curve, you will bring down interest rates across the whole curve. The question is how far out they want to go. But they don't run out of room at 1%."

"What other actions they can take, I'm just not certain," added John Canavan, strategist at Stone & McCarthy Research. "But clearly they continue to work on it. They continue to come up with new and innovative ideas."

Elsewhere in the new-issue market yesterday, Citi priced $240 million of infrastructure improvement general obligation bonds for Ohio. This follows the issuer selling $180 million of the deal during a retail order period Tuesday.

The bonds mature from 2009 through 2018, with term bonds in 2020, 2023, and 2028. Yields range from 3.00% priced at par in 2010 to 5.50% with a 5.375% coupon in 2028. Bonds maturing in 2009 will be decided via sealed bid. The bonds, which are callable at par in 2018, are rated Aa1 by Moody's Investors Service and AA-plus by Standard & Poor's and Fitch Ratings.

Citi also priced $228.2 million of water and sewerage revenue bonds for the Athens-Clarke County, Ga., Unified Government. The bonds mature from 2009 through 2023, with term bonds in 2028, 2033, and 2038. Yields range from 2.52% with a 3% coupon in 2009 to 5.81% with a 5.5% coupon in 2038. The bonds, which are callable at par in 2019, are rated Aa3 by Moody's, AA-minus by Standard & Poor's, and AA by Fitch.

After falling in a flight to quality in the Treasury markets in recent weeks, equities caught some relief following the coordinated rate cut yesterday. The bid for equities didn't hold up for long, though, and investors soon resumed their move to Treasuries in a safe-haven bid.

However, in the afternoon, Treasury yields increased notably. The yield on the benchmark 10-year Treasury note, which opened at 3.50%, finished at 3.71%. The yield on the two-year note opened at 1.45%, and finished at 1.63%. And the 30-year Treasury bond, which opened at 4.03% and finished at 4.11%.

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