The Federal Reserve left monetary policy unchanged yesterday, and bond investors showed their disapproval by pushing long-term yields to the highest levels in 19 months.
Treasury market prices ended lower across the board, led by the 30-year bond which closed down more than 3/4 of a point, to yield 7.62%. That was the highest closing yield since Oct. 11, 1992.
Many fixed-income market players expected the Fed to boost both the federal funds and discount rates yesterday to signal its resolve in fighting inflation. When the central bank failed to signal a change in either of its key lending rates, the market came under selling pressure as investors that had positioned for a tightening closed out those positions.
"The market viewed the lack of tightening as a big negative," said Anthony Karydakis, senior financial economist at First Chicago Capital Markets Inc.
Broadbased strength in the April employment report, coupled with lingering fears about the dollar and signs that U.S. economic fundamentals remain solid, placed pressure on the Fed to boost credit once again, observers generally agreed.
The Fed is almost universally expected to tighten soon, but the timing and magnitude of the move remain in question, Karydakis said, and the uncertainty will continue to put market professionals on the defensive this week and prompt potential buyers to reevaluate their investment strategies.
Because the Fed left rates unchanged yesterday, market players generally expect the next tightening to come after the May 17 meeting of the Federal Open Market Committee. There is still a chance the Fed will boost interest rates today. Analysts generally expect the central bank to raise the federal funds rate 25 basis points to 4%, along with a 50 basis point increase in the discount rates.
In the meantime, bond investors will cope with supply and two potentially negative inflation reports this week. The quarterly refunding, in particular, will probably preclude the central bank from boosting rates anytime before its policy-making arm meets, analysts said.
The Treasury Department is slated to sell $17 billion of three-year notes today and $11 billion of 10-year notes tomorrow as part of its quarterly refunding package.
"Until the Fed gets the tightening out of the way, the market will be in absolute disarray and there will be nothing supporting it," Karydakis said.
As prices of government securities continue to decline, the Treasury yield curve is flattering. Players said a flatter yield curve suggests that the market is gearing up for another tightening in monetary policy.
Bond market observers expect the yield curve to continue to flatten until the market believes the Federal Reserve has reached a neutral monetary policy.
Economists generally expect the curve to flatten by another 20 to 25 basis points from the current level. How quickly the yield curve spread will reach that level depends on investors' perception that the Fed has gotten closer to neutrality on interest rates.
"When the market thinks the Fed has caught up to its tightening need and will be able to leave rates steady for a while, Treasuries will stabilize," said one proprietary trader at a New York primary dealership.
In the last week, the yield spread between the two-year note and 30-year bond narrowed by 17 basis points to stand at 141 basis points. That compares with 300 basis points in January 1993.
Some market players are predicted that when the Fed finally does tighten again, the fixed-income markets will rebound and the yield curve will steepen slightly. However, most agree that a modest bounce in prices is likely, but a sustained bounce or turnaround in market sentiment is unlikely, particularly if the Fed only raises the funds rate by 25 basis points.
In futures, the June bond contract ended down more than 3/4 of a point at 101.19.
In the cash market, the 5 1/2% two-year note was quoted late Monday down 1/4 of a point at 98.20-98.21 to yield 6.23%. The 6 1/2 five-year note ended down 14/32 at 97.19-91.21 to yield 7.06%. The 5 7/8% 10-year note was down more than 3/4 of a point at 88.31-89.03 to yield 7.46%, and the 6 1/4% 30-year bond also was down more than 3/4 at 83.26-83.30 to yield 7.62%.
The three-month Treasury bill was up eight basis points at 4.33%. The six-month bill was up 14 basis points at 4.93%, and the year bill was up 12 basis points at 5.52%.
Corporate securities nosedived with Treasuries yesterday, with market conditions suggesting a gloomy outlook for the primary market this week. Aside from a preferred issue from Citicorp Securities Inc., no corporate debt was priced during the session.
Citicorp priced 7 million shares of $25 cumulative adjustable-rate preferred issues at a 6.40% dividend. Noncallable for five years, the preferred is rated A2 by Moody's Investors Service and BBB by Standard & Poor's Corp.
The rise in global short-term interest rates has increased the potential for bond defaults in Latin America, according to Standard & Poors.
"It appears increasingly likely there will be bond defaults over the next three or four years in this sector of the market," said David Beers, a director in Standard & Poor's international finance department and head of the agency's sovereign ratings group.
The likelihood for such defaults increased because the debtor countries depend more heavily on global bond markets for funding, Beers said.
"We expect that the frequency and magnitude of bond defaults is going to grow as we move through the current decade," Beers said in a report.
The situation is one that investors have not dealt with since the 1930s, and sovereign bond defaults since then have been relatively rare, he said.
However, the defaults of the 1930s had little impact because Latin American countries were largely dependent on bank credit, whereas they now depend much more on global bond markets.
A unique feature of the current credit environment in Latin America is that private issuers there are entering the capital markets for the first time, the Standard & Poor's report said. Defaults by some of the private issuers may be tied to sovereign defaults over the rest of the decade, the report said. Treasury Market Yields Prev. Prev. Monday Week Month3-Month Bill 4.33 4.00 3.606-Month 4.93 4.49 4.071-Year Bill 5.52 5.11 4.652-Year Note 6.23 5.76 5.393-Year Note 5.56 6.11 5.835-Year Note 7.06 6.67 6.447-Year Note 7.11 6.74 6.5510-Year Note 7.46 7.07 6.8630-Year Bond 7.62 7.32 7.32 Source: Cantor, Fitzgerald/Telerate