Fed Will Lower Rates Again Before January Trading History Shows

By Elizabeth Stanton

Sept. 24 (Bloomberg) -- Government bond traders, who predicted six of the last seven recessions, say the Federal Reserve will lower interest rates again before the end of the year as the economy comes to a standstill.

Since the Fed last week lopped half a percentage point off the central bank's target for overnight lending between banks -- the first orchestrated decline in so-called federal funds since 2003 -- traders have pushed the yield on Treasury two-year notes to almost three quarters of a point below the designated 4.75 percent funds rate. In the three previous occasions during the past 20 years when that has happened, policy makers have cut borrowing costs.

``The U.S. economy needs to grow at 2.5 to 3 percent or else it stalls,'' said Bill Gross, manager of the $104.4 billion Total Return Fund, the world's biggest bond fund. ``Historically every time we get close to stall speed the Fed lowers short rates.''

The latest government data shows unexpected job losses in August, sagging core retail sales and no relief in sight for the moribund housing market. Now that U.S. gross domestic product probably is growing at an annualized rate of less than 2 percent, speculation is rampant that another Fed rate cut is assured before January.

Even former Fed Chairman Alan Greenspan provided encouragement to traders when he said in an interview two days after the central bank's Sept. 18 rate decision that the odds of a recession remained ``somewhat more'' than one in three.

Gross, who is chief investment officer of Newport Beach, California-based Pacific Investment Management Co., has predicted lower borrowing costs for a year. He said the federal funds rate will drop to at least 3.75 percent as housing causes the economy's growth rate to slow to between 1 percent and 2 percent from 4 percent in the second quarter.

Note Rally

The benchmark 4 percent note due in August 2009 ended last week little changed at 99 29/32 to yield 4.05 percent, according to New York-based bond broker Cantor Fitzgerald LP.

Two-year notes, more sensitive to changes in monetary policy than longer-maturity debt securities, returned 2.4 percent from mid-year through Sept. 20, according to Merrill Lynch & Co. They haven't done better in a calendar quarter since gaining 3.2 percent in the three months ended Sept. 30, 2002.

``The market is anticipating there could be some further rate cuts down the line,'' said James Sarni, senior managing partner at Payden & Rygel in Los Angeles, which manages $54 billion. ``There has been a shift in the balance of what's driving the Fed from concern about inflation to more concern about growth.''

Changing Focus

At each of their 11 regular meetings from May 2006 until Aug. 7, policy makers said inflation was the main risk facing the economy. Last week they said only that ``some inflation risks remain.'' The yield on the benchmark 10-year note, a 4 3/4 percent security due in August 2017, rose 17 basis points last week to 4.63 percent on concern the Fed is willing to tolerate faster inflation to make sure the economy doesn't slip into recession. A basis point is 0.01 percentage point.

What changed for the Fed was the first drop in U.S. employment in four years in August, an unexpected decline in retail sales excluding automobiles, and the inability of borrowers to roll over short-term debt. The Washington, D.C.- based National Association of Realtors said last week the worst housing slump in at least 16 years will extend into 2008 as tighter loan standards cut into home sales.

Two-year yields were more than half a percentage point lower than the fed funds target from May to December 1989, from August to November 1998 and from October 2000 to April 2001. The Fed lowered rates during and after each period.

Past is Prologue

In 1989 a series of 23 rate cuts began in June and continued until September 1992, taking the fed funds rate to 3 percent from almost 9.75 percent. In 1998 the Fed slashed rates in September, October and November, to 4.75 percent from 5.5 percent. The last series of cuts began Jan. 3, 2001 and ended in June 2003. The rate dropped to 1 percent from 6.5 percent.

Two-year yields declined more than benchmark 10-year yields during each period. Ten-year notes produced larger total returns because the longer a bond's maturity the more its price rises for the same drop in yield.

The economy has gone into recession seven times since 1960, and six were foreshadowed by yields on three-month Treasury bills exceeding yields on 10-year notes. Three-month yields, now 3.73 percent, exceeded 10-year yields from July 2006 through May 2007.

Some areas of the financial markets show that the Fed's cut may be working. U.S. stocks posted their biggest weekly advance since March, and the three-month London interbank offered rate has fallen to 5.20 percent from 5.725 percent on Sept. 7, indicating a resumption of lending by banks.

`Ahead of Itself'

``This has been much more of a capital markets dislocation than a fundamental problem with the U.S. economy,'' said Michael Materasso, co-chair of fixed-income policy committee at Franklin Templeton Investments. ``Unless you think we're going into a prolonged slowdown with an extended period of Fed rate cuts, the short end looks a little bit ahead of itself and priced for a dire economic outcome.''

Materasso said he has been ``selectively adding risk to portfolios'' by buying corporate and mortgage-backed bonds and selling Treasuries. San Mateo, California-based Franklin Templeton oversees $130 billion of bonds.

The Fed's last series of rate reductions began on Jan. 3, 2001, and also triggered advances in stocks and declines in long- maturity Treasuries that continued for three weeks after the move. The reductions aimed to contain the economic fallout of the previous year's stock market crash.

Futures Forecast

Futures on the fed funds rate traded on the Chicago Board of Trade imply a 72 percent chance of a cut to 4.50 percent at the Fed's next meeting on Oct. 31, and 55 percent odds of a reduction to 4.25 percent at the Dec. 11 gathering. The chances of a 4 percent rate by the end of January are about 22 percent.

Interest-rate futures have an accuracy rate of less than 30 percent since 1994 in forecasting the fed funds target, an August 2006 study by the Federal Reserve Bank of St. Louis found. As recently as July 25, futures put the odds of a target lower than 5.25 percent by November at less than 20 percent.

This time, they may prove prescient, according to Lacy Hunt, chief economist at Austin, Texas-based Hoisington Investment Management Co., which oversees about $5 billion of Treasuries. The firm's Wasatch-Hoisington U.S. Treasury fund has returned an average of 4.5 percent a year over the past five years, more than any other actively managed long-maturity U.S. government bond fund, according to Morningstar.

The economy's mortgage-related problems are ``not behind us today and they're not going to be behind us for a long time to come,'' Hunt said. ``This rate reduction was first of what we think will be quite a few over the next couple of years.''

Last Updated: September 23, 2007 11:21 EDT