The bond market's reaction to the Federal Reserve's latest tightening of credit suggests a sea change in investor attitudes that bodes well for Treasury securities, analysts said.
Bonds rallied Tuesday after the Fed increased both the discount and federal funds rates by 50 basis points, citing the need to contain inflation pressures in the face of strains on U.S. manufacturing capacity. The rally was fueled by enthusiasm over the size of the rate increases coupled with the belief that the central bank will not need to raise rates for awhile.
Fixed-income market observers applauded the Fed's Offensive stance on inflation and agreed that the central bank succeeded in reaffirming its brawn in the face of an expanding economy.
"The tightening was the most bullish news the market has had in a long time." said Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson Inc.
That heady feeling did not leave the market yesterday. Evidence of the better tone came when Treasuries generally held their ground, despite a fair amount of selling from accounts attempting to lock in profits after Tuesday's explosive rally.
Prices ended mixed with the two-year note closing unchanged at a yield of 6.14%, and the 30-year bond ending down 3/8 of a point, to yield 7.39%.
The big story yesterday was the impressive performance of the short end of the market, which despite Tuesday's aggressive tightening of credit continued to gain ground. Players were both surprised and impressed by the ability of shortdated Treasuries to weather the effects of higher interest rates in the face of further potential rate moves down the road.
Equally noteworthy has been the return of retail accounts, which poured back into the bond market this week armed with more confidence to own government securities. Renewed interest from larger accounts is a coup for the dealer community, which remains submerged in last week's deluge of debt from the quarterly refunding.
"The consensus among retail is that the Fed is done for the year and that accounts will stay in the market," said Jay Goldinger, chief investment counselor at Capital Insight Inc.
Stability across the maturity spectrum suggests a stark shift in sentiment and bodes well for bonds, fixed-income observers said. The development, they said, is likely to usher in a new period of bullishness in the bond market.
Still, investors are not expected to be complacent spectators of the continued signs of strength in the economy. Bond buyers will closely monitor economic developments, as well as inflation growth, and weigh their holdings accordingly, observers said.
The reluctance of investors to jump back into the market with both feet reflects uncertainty about the outlook for economic growth in the second half of the year, said Hugh Johnson, chief investment officer at First Albany Corp. Bond investors, he said, are looking for signs of a visible slowdown in key economic indicators.
"We need signs of payoff from the five monetary tightenings of this year," Johnson said. Ahead of such evidence, he expects the bond market to trade in current ranges in coming months as accounts get a better read on economic fundamentals.
Some fixed-income observers are expecting the bond market to fully retrace the recent rally as investors and dealers sober up on continued signs of strength in the economy. Bond yields, they said, are poised to move higher as growth in the third and fourth quarters of the year exceeds the Fed's projections.
Joseph Liro, chief economist at S.G. Warburg & Co., drew on recent history as evidence that the bond market is poised to renew its down-trade. The Fed's 50-basis point tightening in May generated a strong bond market rally, touching off a two-week period of price increases, Liro said. However, prices resumed their declines once investors sobered up to the reality of strong growth in the economy.
In coming months, Liro expects the Fed to continue raising interest rates as economic growth persists amid continued upward pressure on industrial commodities prices and stepped-up auto production. "I think the market will give up. [Tuesday's] move and then some," he said.
In Treasury futures yesterday, the September bond contract ended up 3/32 at 104.03.
In the cash markets, the 6 1/8% two-year note ended unchanged at 99.30-99.31 to yield 6.14%. The 6 7/8% five-year note closed down 2/32 at 100.04-100.06 to yield 6.82%. The 7 1/4% 10-year note closed down 4/32 at 100.17-100.21 to yield 7.15%. The 7 1/2% 30year bond ended 12/32 higher at 101.05-101.09 to yield 7.39%.
The three-month Treasury bill closed down four basis points at 4.67%. The six-month bill was down two basis points at 5.10% The year bill also was down two basis points at 5.52%.
Corporate issuers poured into the primary market yesterday as the Fed's rate increase restored stability to the fixed-income universe. More than $1 billion of straight corporate debt from five issuers was priced.
Ford Motor Credit Co. sold $500 million of notes due in 1997 via Goldman, Sachs & Co.; Chevron Capital USA issued $350 million of notes due in 2004 via Goldman Sachs; Avco Financial Services priced $200 million of notes due in 2001 via Salomon Brothers Inc.: Transamerican Financial issued $150 million of notes due in 1997 via UBS Securities Inc.; and Ornda Health corp priced $125 billion of 10-year junk notes via Merrill Lynch & Co. In the secondary market yesterday, spreads of investment-grade issues tightened by 1/8 of a point, while high-yield bonds ended mixed.