The Federal Reserve's failure to announce a widely anticipated discount-rate cut yesterday sent Treasury prices lower, especially at the short end, and resulted in weak demand at the two-year note auction.
Analysts said the losses were limited because the market is still convinced that the economy's paralysis will force the Fed to cut rates eventually.
Late yesterday, the 30-year bond was 1/8 lower to yield 7.75%, and short-term notes were down 1/8 to 1/4 point.
Most participants expected the Fed to lower key rates again in response to a string of weak statistics, and especially the 241,000 decline in November nonfarm payrolls reporter earlier this month.
Treasury Market Yields
Wednesday Week Month
3-Month Bill 4.21 4.24 4.59
6-Month Bill 4.32 4.28 4.71
1-Year Bill 4.42 4.41 4.81
2-Year Note 5.08 5.01 5.48
3-Year Note 5.42 5.39 5.82
4-Year Note 5.52 5.52 5.92
5-Year Note 6.28 6.23 6.52
7-Year Note 6.72 6.71 6.96
10-Year Note 7.17 7.19 7.35
15-Year Bond 7.79 7.55 7.70
30-Year Bond 7.75 7.78 7.89
Source: Cantor, Fitzgerald/Telerate
After the Federal Open Market Committee met Tuesday, many participants believed that Fed would announce a discount rate cut early yesterday morning, before Federal Reserve Chairman Alan Greenspan began testifying before the House Ways and Means Committee and ahead of the two-year note auction.
But no announcement came, and as the morning wore on, prices began to back up, especially at the short end, where traders were preparing to bid on the note auction.
Since the Fed failed to move yesterday, analysts said the next likely opportunity for a rate cut would occur when the December employment report is released on Jan. 10.
Analysts said they were surprised the Fed did not act yesterday, given the weight of the evidence suggesting economic growth has come to a standstill.
But some said Mr. Greenspan's remarks yesterday on Capitol Hill mitigated the market's disappointment by suggesting that the rate cuts have only been delayed.
"You don't have a Fed chairman tell you the economy's dead in its tracks without expecting additional rate reduction," said Steve Ricchiuto, economist at Barclay de Zoete Wedd Government Securities.
And Mr. Greenspan's wariness about fiscal stimulus may have heartened the long end, which is very nervous about Congressional proposals to cut taxes.
Mr. Greenspan came out in support of a capital gains tax cut, but that's nothing new. And he urged Congress to be cautious about worsening the federal budget deficit.
The long end may also have liked Mr. Greenspan's brief remarks about the proposal to cut back longterm treasury ssuance.
Treasury officials have said several times in recent weeks that the government is considering issuing more short-term and less long-term debt to take advantage of the steep yield curve. The Treasury comments have occurred so often that bond traders are convinced the next 30-year sale in February will be reduced to some extent.
Mr. Greenspan said the idea is also being studied by the Fed. The chairman said he could not make a recommendation, but added, "I do suspect there is something there."
Although some studies have said such a change would not have much effect on rates, "I do think that in recent years we've seen some evidence that supply does matter," he said.
Traders blamed the weaker-than-expected two-year results on the Fed's failure to ease earlier in the day.
"The market judged the cost of carry would not be reduced by the Federal Reserve in an immediate fashion, so that introduced some caution into the bidding," said William Sullivan, director of money market research at Dean Witter Reynolds.
The when-issued twos, which got to a yield of 5.02% early in the session, traded as low as 5.12% when it became clear the Fed was not going to act.
And when the auction results came out, the $13.5 billion of notes came at an average yield of 5.12% when traders had expected a 5.11% average, and some bids were accepted at 5.13%.
That compared to the 5.5% coupon and 5.51% average at November's auction. The Treasury said yesterday's average was the lowest recorded since the government began selling two-year notes 18 years ago.
The $30.72 billion of total bids also showed demand had been weak. That works out to 2.27 bids for every security being sold, well below the 2.78-to-1 average ratio at recent two-year sales.
"The combination of a very low coverage ratio and a somewhat higher average yield relegate this auction to being somewhat of a disappointment," Mr. Sullivan said.
Traders said, though, that the two-years held in well after the results were announced.
A note trader said the notes, which were quoted late yesterday at 5.11%, have never hit the stop rate of 5.13% in secondary trading. "That's a good sign."
And today's $9 billion of five-years are expected to see stronger demand, since they yield more than the two-year notes.
Late yesterday, the when-issued five-years stood at 6.29%.
Strong interest in rolling forward into the new five-years from last month's five-year has kept the when-issued fives from cheapening up as much as they should have, the note trader said.
But he was encouraged by the selling that occurred yesterday. "I'd like to see it get behind 6.30% just to bring in some retail interest," the trader said.
Once the five-year auction is completed, the market will settle down to wait for next year.
A coupon trader said the weakness in the economy would continue to support Treasury prices.
But with most institutional accounts having finished for the year, speculative accounts will rule the market for what's left of the year, "and you'll be subject to this kind of quirky behavior," the trader said.
"I think the fundamental influences on the market pretty much came to a close today with the lack of a Fed rate cut," said Douglas Schindewolf, a money market economist at Smith Barney, Harris Upham & Co.
He expects "chopply trading with downward bias" for rest of year "as people do their year-end maneuvering."
The March bond future contract closed 1/16 lower at 100 30/32.
In the cash market, the 30-year 8% bond was 3/32 lower, at 102 24/32-102 28/32, to yield 7.75%.
The 7 1/2% 10-year note fell 1/16, to 102 4/32-102 8/32, to yield 7.17%.
The three-year 6% note was down 7/32, at 101 15/32-101 17/32, to yield 5.42%.
Rates on Treasury bills were higher, with the three-month bill up one basis point at 4.12%, the six-month bill up two basis points at 4.18%, and the year bill seven basis points higher at 4.23%.