It's a maxim among economists that when the German central bank changes monetary policy in Frankfurt, Caterpillar feels the pain in Peoria. Yesterday, it was the U.S. Treasury market that felt the pain.
Germany's powerful Bundesbank cut interest rates yesterday, a move which took the global financial markets by surprise. Gold prices surged immediately following the news, as did prices in European bond markets.
Higher precious metal prices, coupled with signs of strength in the U.S. economy and higher commodity prices, ignited a sharp sell-off in the Treasury market, and the benchmark 30-year bond ended down almost a point and half, to yield 5.91%.
Traders said a lack of consensus among market participants about the direction of the U.S. economy and the absence of significant economic indicators on which to focus made Treasuries even more vulnerable to a rise in the Commodity Research Bureau's index of commodity prices and events abroad than would normally be the case. Participants generally believe the market will maintain recent ranges until next week's gross domestic product report.
Market players interpreted the Bundesbank's rate action yesterday as part of a broad, aggressive effort by European central banks to stimulate their economies.
Declining interest rates abroad are a negative for the U.S. fixed-income markets because more foreign demand for U.S. exports is likely to boost the North American economy and result in higher inflation, participants said. It is also a negative development for investment, as declining interest rates abroad will provide investors with greater opportunities for capital gains than in the U.S., where rates are likely to hold steady.
"The German rate cuts are expansionary, and they'll have an adverse effect on Treasuries," said Charles Lieberman, director of financial markets research at Chemical Securities.
Lieberman said the deterioration of foreign trade in the current business cycle has hampered economic growth in the U.S. and acted as a crutch for fixed-income markets. But with rates moving lower in Europe, the appetite for U.s.-made products is likely to cause some indigestion for the Treasury market and prompt investors to reevaluate the lofty price levels of dollar-denominated securities, Lieberman said.
The Bundesbank said it was lowering its discount rate to 5.75% from 6.25%, and its Lombard rate to 6.75% from 7.25%. Market players had expected a rate cut by the German central bank before yearend, but the announcement was not expected after yesterday's council meeting.
Expectations that other central banks will follow suit have made European securities more attractive. By opening the door for other European central banks to ease monetary policy, the rate cuts are expected to reinvigorate European economies and boost inflation.
Gold, used by investors as an inflation hedge, has firmed on this premise. Silver and platinum firmed on expectations that the German rate cut would step up industrial demand for both metals.
The Treasury market experienced significant price declines in overseas trading immediately following news of the Bundesbank's policy move, but the bulk of the declines took place in the New York trading session.
Treasury prices slid lower throughout the day due to further declines in bond futures and strong news on the manufacturing sector of the economy.
Futures eroded in response to the higher gold and commodity prices and technical weakness. The selling carried over into the cash market and was accelerated by a huge jump in the Philadelphia Federal Reserve's survey on manufacturing activity. The diffusion index surged to 15.1 in October from 0.7. The employment index was 10.7, up from -7.7, and new orders were 15.1 versus 7.1. Prices paid fell to -0. in October from 9.1.
Kathleen Stephansen, senior economist at Donaldson, Lufkin & Jenrette Securities Corp., said the survey suggested a moderate pickup in the manufacturing sector, particularly in employment.
The long end of the market took the brunt of the yesterday's sell-off due to the surge in gold. Contributing to the pressure on the long and intermediate sectors of the curve was a movement of cash out of longer Treasuries and back into mortgage-backed securities, as prepayment speeds have slowed in recent sessions, Stephansen said.
The market was also hit with speculation about the significance of the Treasury's lower borrowing need for the year. The House Budget Committee said it revised its estimated fiscal 1993 federal budget deficit to less than $252 billion, compared with an initial estimate of $266 billion and an earlier estimate of $310 billion.
The committee said higher thananticipated tax receipts and lowerthan anticipated costs for the savings and loan bailout and lower health-care costs and interest rates were responsible for the revision to their estimate.
Economists said that the lower borrowing needs suggest the U.S. economy could turn in a better performance in the second half of the year than many analysts expect.
Robert Brusca, chief economist at Nikko Securities Co., said an increase in corporate and individual tax receipts points toward healthier payrolls than many other indicators might.
After digesting the market's sharp declines yesterday, participants generally agreed that the backup in yields will help the market maintain current levels. In what has become a recurring theme for Treasuries in recent sessions, selling has merely pushed yields higher and brought buyers back into the market.
Kathleen M. Camilli, chief economist at Maria Fiorini Ramirez Inc., said that the U.S. economy's slow growth, low inflation scenario is still in place and expects the market to range-trade until economic statistics provide the market with direction.
"It's a wait and see trade right now," Camilli said.
In futures, the September contract ended down almost 3 1/2 points to 119.27.
In the cash markets, the 3 7/8% two-year note was quoted late yesterday down 2/32 at 100.01-100.02 to yield 3.84%; the 4/34% five-year note ended down 10/32 at 100.04-100.06 to yield 4.70%; the 5 3/4% 10-year note was down 22/32 at 103.03-103.07 to yield 5.32%; and the 6 1/4% 30-year bond was down 46/32 at 104.18-104.22 to yield 5.91%.
The three-month Treasury bill was unchanged at 3.05%; the six-month bill was up two basis points at 3.15%; and the year bill was up one basis point at 3.27%.Treasury Market Yields Prev. Prev. Thursday Week Month3-Month Bill 3.05 3.01 2.966-Month Bill 3.15 3.10 3.131-Year Bill 3.27 3.20 3.362-Year Note 3.84 3.79 3.903-Year Note 4.12 4.03 4.185-Year Note 4.70 4.59 4.817-Year Note 4.89 4.76 4.9810-Year Note 5.32 5.21 5.4230-Year Bond 5.91 5.84 6.06Source: Cantor, Fitzgerald/Telerate