The municipal market was unchanged yesterday, despite Treasury gains, as traders sit on the sidelines in the throes of more market uncertainty.

The Treasury market firmed yesterday on a flight-to-safety bid after news last night that the Federal Reserve cut the primary credit discount rate - the lending rate for loans to financial institutions - 25 basis points to 3.25%, and that JPMorgan Chase & Co. had agreed to purchase Bear, Stearns & Co., with the Fed providing $30 billion of funding.

However, coming a day prior to the Fed's scheduled monetary policy meeting, many muni market participants chose to remain on the sidelines.

"Certainly there's a lot of buying in the Treasury market," a trader in New York said. "They are looking for safety, and even though munis are pretty safe, there's been some uncertainty lately, so people are just running for cash and Treasuries. It's rough, because now a lot of people are on the sidelines. This certainly has brought a lot of uncertainty into the market, and that's not fun."

The yield on the benchmark 10-year Treasury note, which opened at 3.44%, finished at 3.35%. The yield on the two-year note was quoted near the end of the session at 1.36%, after opening at 1.48%.

According to Matthew Moore, Treasury strategist at Banc of America Securities LLC, fallout from those events is the driving force behind yesterday's Treasury rally, as it is "driving investors to the relative safety and liquidity of Treasuries." However, he doesn't believe the Treasury gains are sustainable for an extended period of time.

"I think in the short term we can continue this rally and have lower yields, but in the longer term, it's hard to sustain these low yields for an extended period, because of the other alternatives," Moore said. But right now, investors are running scared to Treasuries.

Matt Fabian, managing director at Municipal Market Advisors, said that yesterday's events further indicate that "municipals are now historically uncorrelated with the Treasury market." He said that, because of this, Treasuries "are not a valid hedge" for a municipal investor, making munis "in a sense, un-hedgeable."

"So what do you do? If you can't hedge them, you don't buy them. And if you have to buy them, then you wind up operating with a low hedge ratio, and then your duration kicks out, so then you have to buy short bonds," he said.

"And even if you wanted to participate in the market like this, even if you had a program to do it, in order to get investors to bite on a risk-adjusted return basis, you have to offer them some kind of enormous return," Fabian continued. "The only way you exaggerate returns is by increasing the leverage, and that's not what you do now. It's very grim indeed for the hedged and leveraged investors. It's really not a good context."

Alan Levenson, chief economist at T. Rowe Price Associates Inc., said that the decisions to support the buyout of Bear Stearns and to cut the discount rate were "somewhat separate decisions" for the Fed, but the "urgency was in getting the deal done with JPMorgan and Bear Stearns."

He said that, with the Fed scheduled to meet today, expectations should be for significant rate cuts to both the federal funds rate target and the discount rate, which now stand at 3% and 3.25%, respectively.

"The Fed doing what they did [Sunday] is a reinforcement of how aggressively they're trying to move to try to contain the financial market turmoil and to support the economy," Levenson said. "In that regard, it would suggest that the last thing the Fed wants to do is disappoint the markets."

Fed funds futures yesterday reported an 89% expectation in the market of a rate cut of 100 basis points to 2%. The remaining 11% called for a cut of 125 basis points, to 1.75%.

Levenson also said that "looking at the way the dollar is trading, and looking at how commodities are trading, it suggests to me that it might be helpful to the financial markets and to the economy for the Fed to say that after what they do [today], they've done enough."

Levenson believes that the Fed will "absolutely" bring the discount rate down again along with the federal funds rate, but doesn't have a strong feeling as to whether or not they will further alter the now 25-basis-point spread between the discount rate and the fed funds rate.

"They made a pretty big change in operating procedure six years ago, in bringing the discount rate from below the funds rate to above the funds rate," he said. "They've wanted it to be a penalty rate, and in the current episode, increasingly, reduce the spread. I don't want to say they won't reduce it further, but I don't have a particular reason to forecast that they're going to either."

Also, the Federal Reserve Board has included investment-grade municipal securities in the types of collateral it will accept from broker-dealers for repurchase agreements. To help the financial markets, the Federal Reserve Sunday announced that the Federal Reserve Board of New York had been granted the authority to establish a primary dealer credit facility, an overnight loan facility that will provide funding to primary dealers in exchange for a specified range of eligible collateral. The collateral listed as eligible on the Fed's Web site includes investment-grade municipal, corporate, mortgage-backed, and asset-based securities, for which a price is available.

Activity in the new-issue market was light yesterday, ahead of a $4.9 billion slate of deals expected to be priced in the primary market this week. However, if Bear Stearns liquidates more paper and sends more supply into the secondary market this week, it could impact the market.

"If they were to begin to sell, secondary supply is bad for prices, whereas primary supply is typically good," Fabian said. "In a week where we already have a lower primary supply, a surge of secondary selling, which I would take as unlikely, just because it's so early, would probably mean the market is going to be hard-pressed to maintain a positive attitude."

Fabian also said that, while one might expect Bear Stearns to ultimately begin selling unsold balances from deals it sold in the primary market, he's not sure it will happen any time soon.

"The statement was that Bear Stearns is still open for business, and that they're doing business, that they're not selling off," he said. "I'm taking that to mean that they're not selling off their inventories right yet."

In economic data released yesterday, the Empire State Manufacturing Survey "indicates that conditions for New York manufacturers deteriorated further in March," the Federal Reserve Bank of New York reported, as the general business conditions index slumped to an all-time low of negative 22.23 in March from negative 11.72 in February. The previous low for the index was negative 19.6 in November 2001. Economists surveyed by IFR Markets had expected the index would be negative 6.30.

Industrial production in the nation was down 0.5% in February while capacity utilization fell to 80.9. The drop in production level followed a 0.1% increase the previous month, while January capacity use was 81.5. IFR Markets had forecast a 0.1% decrease in production, and an 81.3% level for capacity utilization.

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