Prices of Treasury securities headed for the stars yesterday after the Federal Reserve announced an aggressive tightening of monetary policy.
The Fed increased by 50 basis points both the discount rate and the federal funds rate, citing the need to contain inflation pressures in the face of strains on capacity in the national economy. The discount rate rose to 4% from 3.5% and the federal funds rate to 4.75% from 4.25%. The action was identical to that taken by the Federal Open Market Committee on May 17.
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 Fed's move was aggressive and hence is being interpreted as a strong commentary on its anti-inflationary policy," said Samuel Kahan, chief economist at Fuji Securities Inc. "The prospect of a slowdown in the economy has now been increased and the market has taken that as a positive sign."
Amid signs that the U.S. economy continues to navigate a steady path toward full capacity and evidence that price pressures are stirring, investors grew dependent on the central bank to tighten credit conditions and renew its vow to keep inflation under wraps. By all accounts, the Fed succeeded in doing just that.
With the tightening likely to help the long end more than the short end, the strongest upward price moves were seen in the seven- and 10-year notes along with the 30-year bond. The long bond led the move higher, roaring up more than 1 1/2 points, to yield 7.36% late yesterday. The short end posted marginal gains, with the two-year note up 1/8 of a point at a yield of 6.20%.
Market observers said the strong dose of monetary restraint succeeded in lifting the long end out of its recent slump. Optimism among long-term bond investors stems primarily from the belief that tighter credit will keep the economy from overheating and relieve much of the overhang from last week's refunding auctions.
The short end also held its own. Short-dated Treasuries gained ground yesterday as participants speculated that the aggressiveness of the latest tightening will enable the central bank to sit pat for a while, removing an element of uncertainty from the market.
Fixed-income observers generally expect the market to extend yesterday's gains as more retail accounts come off the sidelines and purchase Treasuries. Their optimism stems from the belief that the Fed's latest tightening will restore calm to the bond market and make investors more confident about buying government paper.
Tony Crescenzi, head of fixed income at Miller, Tabak, Hirsch & Co., drew on recent history as evidence that the bond market is poised to build on yesterday's gains. In May, he said, the long bond rallied sharply after the Fed's tightening and "there's a feeling that behavior will repeat itself."
Primary among the Fed's accomplishments yesterday was that it regained its credibility with the bond market, said Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson Inc. The Fed's move was a clear attempt to demonstrate that the central bank is willing to act to head off inflation even if the mainstream indicators of price pressures, such as the consumer and producer price indexes, remain well behaved.
Bolstering the market's performance yesterday was the belief that the central bank will leave rates unchanged until November, when the FOMC is scheduled to meet again. In a press release, the Fed said that "these actions are expected to be sufficient, at least for a time, to meet the objective of sustained, noninflationary growth."
Participants interpreted that to mean that the central bank is not likely to tighten before the Nov. 15 meeting of its policymaking arm.
"What the Fed is saying is that this latest tightening is not the start of a series of rate increases but a reaction to what recent numbers are saying about the economy," said Fuji's Kahan.
Wall Street economists interviewed yesterday agreed that the Fed was justified in reining in credit. "This is an appropriate tightening, a normal occurrence in a mature expansion," said Eugene J. Sherman, director of research at M.A. Schapiro & Co.
The move, Sherman said, was justified because the economy is operating at a nonaccelerating inflation rate of resources utilization. That is to say the unemployment rate is low, with pockets of scarcity; the capacity utilization rate is high; commodities prices, particularly raw industrials, have been rising rapidly since October; vendor delivery times are lengthening; and inflation expectations have turned upward, he said.
Despite previous tightenings this year, Sherman said, the interest rate-sensitive sectors of the economy maintained momentum throughout the second quarter and early indications suggest a continuation in the third quarter. Moreover, he said, loan demand, especially business loan demand, has been rising at an accelerating rate all year despite the higher prime and other interest rates.
Wesbury agreed that the Fed had little choice but to raise interest rates, particularly against the backdrop of recent economic reports. The stronger July housing starts report combined with a surprise increase in industrial production during July suggested that the economy remains on a firm foundation of growth, Wesbury said.
"The tightening was the most bullish news the market has had in a long time," Wesbury said.
Housing starts rose 4.7% in July, climbing back to 1.415 million units at an annual rate following a 9.4% decline posted in June. In July, industrial production rose 0.2%, despite a 2.3% decline in auto and track production.
However, not all Wall Street analysts believe that the Fed's 50-basis point moves were warranted by current economic fundamentals. Some observers believe the aggressive tightening could unnecessarily raise warning flags in the market that inflation is rising faster than conventional measures currently suggest.
The analysts argue that a more gradual increase of a quarter point in the funds rate target would have allowed the Fed to send a message of restraint to the bond market, while at the same time giving it room to analyze upcoming reports on the economy and decide on the proper level for short-term rates.
"While everyone understands the Fed needs to stay ahead of the inflation curve, it's not good to go too far," said a market strategist at a New York-based primary dealership. "I think the Fed went a bit too far and that people will slowly realize that."
In the futures market, the September bond contract was up more than a point at 104.00.
In the cash markets, the 6 1/8% two-year note ended up 4/32 of a point at 99.29-99.30 to yield 6.15%. The 6 7/8% five-year note was up 19/32 at 100.06-100.08 to yield 6.81%. The 7 1/4% 10-year note was up more than a point at 100.21-100.25 to yield 7.13%. The 7 1/2% 30-year bond rose more than 1 1/2 points at 101.16-101-20 to yield 7.36%.
The three-month Treasury bill closed up two basis points at 4.71%. The six-month bill was down three basis points at 5.13%. The year bill was down five basis points at 5.53%.
--Joyce Hanson contributed to this column. Treasury Market Yields Previous Previous Friday Week Month3-Month Bill 4.71 4.52 4.356-Month Bill 5.13 5.09 4.791-Year Bill 5.53 5.57 5.232-Year Note 6.15 6.20 5.913-Year Note 6.45 6.49 6.225-Year Note 6.81 6.94 6.717-Year Note 6.97 7.10 6.9110-Year Note 7.13 7.29 7.1330-Year Bond 7.36 7.56 7.46 Source: Cantor, Fitzgerald/Telerate