Bond traders see another Fed cut before January

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 per cent funds rate.

In the three previous occasions during the past 20 years, when that has happened, policy makers have cut borrowing costs.

"The US economy needs to grow at 2.5 to 3 per cent 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 the US gross domestic product probably is growing at an annualised rate of less than 2 per cent, 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 September 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 per cent as housing causes the economy's growth rate to slow to between 1 per cent and 2 per cent from 4 per cent in the second quarter.

The benchmark 4 per cent note due in August 2009 fell today, with the yield rising 1 basis point to 4.06 per cent as of 8:57 am in London, according to New York-based bond broker Cantor Fitzgerald. Its price was little changed at 99 28/32.

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

At each of their 11 regular meetings from May 2006 until August 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 per cent security due in August 2017, rose 17 basis points last week to 4.63 per cent 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 US 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, DC-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.

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 per cent.

In 1998 the Fed slashed rates in September, October and November, to 4.75 per cent from 5.5 per cent. The last series of cuts began Jan. 3, 2001 and ended in June 2003. The rate dropped to 1 per cent from 6.5 per cent.

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 per cent, 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. US stocks posted their biggest weekly advance since March, and the three-month London interbank offered rate has fallen to 5.20 per cent from 5.725 per cent on September 7, indicating a resumption of lending by banks.

"This has been much more of a capital markets dislocation than a fundamental problem with the US 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 January 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 on the fed funds rate traded on the Chicago Board of Trade imply a 72 per cent chance of a cut to 4.50 per cent at the Fed's next meeting on October 31, and 55 per cent odds of a reduction to 4.25 per cent at the December 11 gathering. The chances of a 4 per cent rate by the end of January are about 22 per cent.

Interest-rate futures have an accuracy rate of less than 30 per cent 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 per cent by November at less than 20 per cent.

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 US Treasury fund has returned an average of 4.5 per cent a year over the past five years, more than any other actively managed long-maturity US 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.''