The municipal market was weaker yesterday, as the Federal Open Market Committee held the federal funds rate unchanged at 2%, while participants continued to deal with the fallout from Lehman Brothers' Chapter 11 bankruptcy filing and news that Bank of America will purchase Merrill Lynch & Co.
Traders said tax-exempt yields were higher by about five basis points overall, though some bonds on the long end of the market aare weaker by 10 or more basis points.
"There are a couple of distressed trades bringing down the market, but there's still not much going on," a trader in Chicago said. "It's still fairly illiquid, and it's really just one or two big trades throwing things off. The threat of [American International Group Inc.] trying to sell off municipal holdings is a pall that hangs over us, but the managers there know they can't do that in an orderly fashion. There's just not enough balance sheet available for others to take that on."
The FOMC held the federal funds rate target unchanged yesterday at 2%, following market speculation that rates would be cut, perhaps by as much as 50 basis points.
Joel Naroff, president of Naroff Economic Advisors, wasn't surprised by the decision to hold rates unchanged, but was somewhat disappointed that the Fed "didn't make it a little clearer" that liquidity was their focus.
"I think it's what we all assume, but I think it would have smoothed over the decision a lot more" had the Fed been more explicit in stating that, he said.
Naroff also said that any rate cut would have had to be more than one quarter of a percentage point.
A 25-basis-point cut "would have just been plain silly," he said. "So they would have had to do 50, but if they really wanted to make a statement, then that would have been 100 basis points, given the Fed's already done 75. So I couldn't see that the Fed wanted to get the rate close to 1%."
"They're obviously reluctant to cut the funds rate," added Jim O'Sullivan, senior economist at UBS. "They are using their other liquidity tools for now. Ultimately, we'll probably get enough weakness in the economy that they will have to cut the funds rate, but the signals they're giving at this point is that they don't want to. It was debatable. We thought they would ease, but we thought it was a close call."
Trades reported to the Municipal Securities Rulemaking Board yesterday showed losses. A dealer sold to a customer insured California 5s of 2033 at 4.40%, up four basis points from Monday. An interdealer trade of Los Angeles Community College District 5s of 2033 yielded 4.95%, up seven basis points from Monday. Bonds from an interdealer trade of New York's Triborough Bridge and Tunnel Authority 5s of 2038 yielded 5.05%, up 15 basis points from Monday.
The bankruptcy of Lehman Brothers had a direct impact on Main Street Natural Gas Inc. project revenue bonds. The rating agencies have all downgraded the bonds, because Lehman, through a subsidiary, guarantees both the supply of gas and acts as the gas purchase agreement guarantor. Yesterday, a dealer bought from a customer 2033s with a coupon of 6.25% to yield 25.168%.
The Treasury market, however, which posted gains in the morning, finished the session weaker. The yield on the benchmark 10-year Treasury note, which opened at 3.38%, finished at 3.46%. The yield on the two-year note was quoted near the end of the session at 1.88% after opening at 1.70%. The yield on the 30-year Treasury finished at 4.07% after opening at 4.02%.
The Treasury market has fluctuated wildly the past two days around news of the financial sector, basically disregarding the economic indicators it usually trades on, said John Canavan, a strategist at Stone & McCarthy Research. Following this weekend's turmoil, a flight-to-quality on Monday sent yields plummeting. The 30-year Treasury bond fell to an historic low of 4.02%.
Yesterday, the flight-to-quality sent yields even lower in the morning, before rebounding ahead of the FOMC's decision. Reports that the Fed had come up with a plan to support beleaguered insurer AIG through loans helped push yields back up as investors moved away from the safe-haven bid and into equities.
The Dow Jones industrial average finished up 141.51 points to 11,059.02 yesterday, after falling 504 points on Monday.
"Clearly at this point, the trade is all about the financial strife," Canavan said. "From minute to minute, the extent of the safe-haven bid is all that counts. The [economic] numbers the past couple of days have not been bad for the market. They've been in good, in fact, but they've had no impact."
In economic data released yesterday, the consumer priced index dropped 0.1% in August, after a 0.3% dip the previous month. Economists polled by IFR Markets had predicted a 0.1% decline.
Also, the CPI core rose 0.2% in August, after a 0.1% uptick the prior month. Economists polled by IFR predicted a 0.2% gain.
Although the Fed voted unanimously to hold rates unchanged, it did provide some significant changes to the language in its statement.
One included the addition of the sentences, "strains in the financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending."
Another saw the phrase reading, "the Committee will monitor economic and financial developments" have the word "carefully" added to the end of it.
However, according to O'Sullivan, the most surprising change in the statement was the inclusion of the sentence reading, "the downside risks to growth and the upside risks to inflation are both of significant concern to the committee."
"In other words, they were split between which was a greater risk. And I don't think there's a large number of people out there who would put the risk to inflation up at the same level as the risk to the economy right now," O'Sullivan said. "So that one kind of surprised me more than anything else. That was the most remarkable element of the statement. One would have thought that they would be a little more biased towards the concerns about the economy. Indeed that may be the most important message that they were sending in it, that they're not panicked by it."
Also, options on fed futures priced the chance of a cut by the end of the Fed's December meeting a 61%, according to the Chicago Board of Trade. Last week, the market had priced with 87% probability there would be no change before the end of the year.
O'Sullivan agreed with the consensus.
"If the Fed didn't cut now, I would find it hard to think that they're going to cut unless we really do have much more of a meltdown than we've been seeing at this point," he said.
Activity in the new-issue market was fairly light yesterday.