Treasuries Fall After Fed Shows Reluctance to Cut Rates Further

By Sandra Hernandez and Elizabeth Stanton


Oct. 31 (Bloomberg) -- Treasuries fell after the Federal Reserve lowered interest rates for a second time in two months and suggested additional reductions may prove unnecessary.

Two-year notes, more sensitive than longer-maturity debt to Fed rate changes, dropped the most since August. Yields touched two-week highs as traders pared bets on more cuts in the central bank's target for the overnight lending rate between banks.

``They're telling you they're on hold, probably through December,'' said Charles Comiskey, head of U.S. government bond trading in New York at HSBC Securities USA Inc., one of the 21 primary dealers that trade directly with the Fed. ``The two-year note needs rate cut after rate cut after rate cut, and is not going to get it.''

The yield on two-year notes climbed 13 basis points to 3.95 percent at 4:36 p.m. in New York, according to bond broker Cantor Fitzgerald LP, the biggest increase since Aug. 22, and the highest since Oct. 17. The price of 3 5/8 percent securities maturing in October 2009 fell 8/32, or $2.50 per $1,000 face amount, to 99 12/32.

The benchmark 10-year note's yield rose almost 9 basis points to 4.47 percent, the biggest increase since Oct. 5 and the highest yield since Oct. 19.

The gap between two- and 10-year yields narrowed for a third straight day to 53 basis points, the smallest since Oct. 16. The differential widened to 64 basis points last month, the biggest in two years, as traders wagered Fed rate cuts would lead to faster economic growth and inflation.

`Help Forestall'

Fed policy makers at a meeting in Washington lowered their target for the overnight lending rate between banks to 4.5 percent from 4.75 percent, as forecast by most economists in a Bloomberg poll.

``Today's action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets,'' the Federal Open Market Committee said in a statement announcing its decision on rates.

At their Sept. 18 meeting, Fed policy makers lowered the target rate a half-percentage point from 5.25 percent, citing the potential for the housing slump to hurt the economy.

The odds of a quarter-percentage-point cut at the Fed's next meeting on Dec. 11 slipped to 40 percent from 66 percent yesterday, based on the prices of federal funds futures contracts listed on the Chicago Board of Trade.

`Upside Risks'

``The Fed doesn't seem to be scared stiff about the direction of economic growth,'' said Michael Materasso, the New York-based co-chair of the fixed-income policy committee at Franklin Templeton Investments, which oversees $130 billion of bonds. ``I see less of an impetus to be massively buying Treasuries.''

Inflation risk also may keep the central bank from lowering rates further, the statement said.

``The Committee judges that, after this action, the upside risks to inflation'' created in part by rising energy and commodity prices ``roughly balance the downside risks to growth,'' it said. Crude oil futures rose to a record $94.74 a barrel in New York today, leading the UBS Bloomberg CMCI Index of 26 commodities to a record.

Inflation expectations rose as measured by the yields on Treasury Inflation Protected Securities, or TIPS.

For the TIPS maturing in July 2017, the 2.09 percent yield trails the 10-year note's yield by 2.36 percentage points. The difference, representing the expected average inflation rate over the life of the securities, compares with 2.18 percentage points on Sept. 10.

A report tomorrow is expected to show the Fed's preferred inflation gauge, an index of prices excluding food and energy items, rose 1.8 percent in September from the previous year. Fed Chairman Ben S. Bernanke and several other policy makers have said their ``comfort zone'' for so-called core inflation is 1 percent to 2 percent.

`This Is It'

``Based on current conditions this is it for the year'' from the Fed, said Alex Li, an interest-rate strategist in New York at Credit Suisse Securities USA LLC, another primary dealer. ``The front end will probably see more room to rise in yield as people price out expectations for an additional rate cut.''

Treasuries fell earlier after reports showed the economy unexpectedly accelerated in the third quarter and companies added more employees to payrolls in October than economists forecast. A Labor Department report on Nov. 2 is forecast by economists to show U.S. employers this month created the fewest jobs since June.

Employment Growth

Companies in the U.S. created 106,000 jobs in October, ADP Employer Services said, compared with a median forecast of 58,000 among economists polled by Bloomberg News. Gains averaged about 90,000 a month from January through July.

The Labor Department's employment report for October, to be released Nov. 2, is forecast to show employers including the government added 80,000 people to payrolls, compared with 110,000 in September. An ADP increase of 106,000 implies total employment growth of 131,000, according to primary dealer RBS Greenwich Capital.

Gross domestic product grew at an annual rate of 3.9 percent in the third quarter, the most since the first three months of 2006, compared with a 3.8 percent pace in the prior quarter, the Commerce Department said. Economists' median forecast was 3.1 percent. The inflation rate for items purchased by consumers, the Federal Reserve's preferred gauge of prices, rose 1.8 percent, compared with 1.4 percent in the second quarter and more than forecast.

Spending by consumers, which accounts for about two-thirds of the economy, grew 3.0 percent, less than forecast, and is projected to slow further in the current quarter as falling real estate values impair confidence.

Respond If Warranted

The median forecast for GDP growth in the current quarter is 1.8 percent, which would be the slowest since the first quarter when the economy grew at a 0.6 percent rate.

The Fed statement acknowledged the potential for slowing growth, saying ``the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.''

``They're giving themselves enough room on either side to go ahead and respond if it's warranted,'' said David Glocke, who manages $32 billion of Treasuries at Vanguard Group Inc. in Valley Forge, Pennsylvania.

Treasuries still are headed for a fourth straight monthly gain as the 10-year yield has declined from 4.59 percent at the end of September. Merrill Lynch & Co.'s Treasury Master Index rose 1.2 percent through yesterday, three times as much as the Standard & Poor's 500 Index including reinvested dividends.

Treasuries returned 6.2 percent this year through yesterday, on pace for their best year since 2002.