By Sandra Hernandez and Deborah Finestone
Jan. 4 (Bloomberg) -- The Treasury market is off to its best start since 2001 after U.S. unemployment rose to the highest rate in more than two years, increasing speculation the Federal Reserve will cut borrowing costs more than forecast to prevent a recession.
Two-year note yields touched the lowest level since November 2004 as traders for the first time priced in a 50 percent probability the Fed will lower its target interest rate to 3.75 percent from 4.25 percent, when policy makers meet at the end of the month. Treasuries had gained earlier this week on concern that the worst housing slump in 16 years will slow economic growth.
``The economy is slowing, it's slowing dramatically and quickly,'' said Stewart Taylor, who trades Treasuries in Boston at Eaton Vance Management, which oversees about $4 billion of taxable bonds. ``You're going to be hard-pressed to find any reason to sell bonds in the near future.''
The yield on the two-year note fell 8 basis points, or 0.08 percentage point, to 2.73 percent at 4 p.m. in New York, according to bond broker Cantor Fitzgerald LP. The price of the 3 1/4 percent security due in December 2009 rose 5/32, or $1.56 per $1,000 face amount, to 101. It touched 2.66 percent, the lowest since November 2004.
Treasuries of all maturities have returned 0.743 percent since Dec. 31, according to a Merrill Lynch & Co. index. That's the most since 2001, when the Fed cut rates for the first time in two years at an unscheduled meeting.
The difference, or spread, between the yields on two- and 10-year notes widened to the most since 2004, indicating traders are favoring short-maturity notes in anticipation of more aggressive rate cuts by the Fed. The so-called yield curve steepened as much as 4 basis points, to 113 basis points.
``Any negative news has investors allocating money into a very safe investment and that's what we're seeing at the short end of the Treasury market,'' said Gary Pollack, who helps oversee $12 billion as head of fixed income trading at Deutsche Bank AG's Private Wealth Management unit in New York. ``The Fed will have to get the funds rate to 3.5 percent and maybe 3.25 percent before the economy starts to bounce back.'' He spoke in an interview on Bloomberg Radio.
The unemployment rate rose to 5 percent as U.S. employers added 18,000 jobs in December, compared with a revised 115,000 increase the previous month, the Labor Department said in Washington. Excluding a gain in government jobs, payrolls fell for the first time since July 2003.
Fed funds futures contracts on the Chicago Board of Trade showed a 68 percent chance that policy makers will lower the target rate for overnight lending between banks by half a percentage point. The odds were 34 percent yesterday and zero a week ago. Fed policy makers are scheduled to meet on Jan. 30.
Economists surveyed by Bloomberg expect policy makers to reduce the benchmark rate a quarter-point to 4 percent by the end of the first quarter, according to the median of 63 responses.
``The debate is about how much more the Fed needs to cut rates, not if,'' said Colin Lundgren, head of institutional fixed income in Minneapolis at RiverSource Investments, which oversees $100 billion of bonds. ``The Fed may have to end up reversing course aggressively to fight inflation. That fight seems to be for another day, at least that's how the bond market is treating it.''
Two- and 10-year notes have had their biggest weekly gains since the week ended Oct. 19, after home foreclosures led three of the biggest U.S. banks to report declines in third-quarter profit.
Treasuries have extended gains from 2007, when a collapse in the market for subprime loans led banks to write down $97 billion in assets and borrowing costs to soar. U.S. government debt last year posted the best annual returns since 2002 on concern that the credit meltdown would slow the economy.
The Fed today said it will increase the size of two scheduled auctions of emergency loans by 50 percent to $30 billion beginning with the next offering, scheduled for Jan. 14.
The Fed is `intimating that there's more of a demand for liquidity than we originally thought,'' said T.J. Marta, a fixed-income strategist in New York at RBC Capital Markets. ``The market is completely focused on risks to growth and risks to the financial system.''
Term Auction Facility
The Fed established the temporary Term Auction Facility, dubbed TAF, in December to provide cash after interest rate cuts failed to break banks' reluctance to lend amid concern about losses related to subprime mortgage securities.
Since the first of the auctions on Dec. 17, companies' cost to borrow in dollars for three months has fallen to the lowest in two years, suggesting central banks are succeeding in spurring bank lending.
Odds of a cut in the funds rate to 3.75 percent increased this week as reports showed weakness in private employment indicators and manufacturing.
The Institute for Supply Management's factory index for December shrank to 47.7, the lowest level since April 2003. A figure below 50 indicates contraction. Companies in the U.S. added 40,000 jobs in December, down from a revised 173,000 the previous month, ADP Employer Services said yesterday. ADP does not take into account government hiring.