Treasury Two-Year Notes Rise, Bonds Fall After Fed Rate Cut

Sept. 18 (Bloomberg) -- Treasury two-year notes rose after the Federal Reserve lowered its benchmark interest rate a half- percentage point to blunt the impact of a slowdown in housing. Longer-dated debt fell as the central bank said inflation risks remain.

Fed policy makers lowered their target for the overnight lending rate between banks to 4.75 percent at a scheduled meeting in Washington, the first change since June 2006 and the first decrease since June 2003.

``They have clearly left the door open for more,'' said William O'Donnell, U.S. government bond strategist at UBS Securities in Stamford, Connecticut. ``The long end might have taken the somewhat aggressive stance of the Fed a little personally especially with headline inflation running fairly high and the Fed acknowledging that some inflation risk does exist.''

The yield on two-year notes fell 6 basis points, or 0.06 percentage point, to 4.01 percent at 2:30 p.m. in New York, according to bond broker Cantor Fitzgerald LP. Ten-year note yields rose 5 basis points to 4.51 percent.

The two-year note yield tumbled from a 10-month high of 5.13 percent on June 13 as expectations of slower economic growth and rate cuts stemming from the real estate slowdown prompted a surge in demand for U.S. government debt.

The central bank also reduced the rate it charges banks, known as the discount rate, by 0.50 percentage point to 5.25 percent. The Fed last lowered it on Aug. 17 from 6.25 percent.

Discount Window Loans

A discount rate cut became likelier after Fed data released last week showed loans to banks increased by about $6 billion, said T.J. Marta, an interest-rate strategist in New York at RBC Capital Markets, before the announcement today. Discount window loans outstanding as of Sept. 12 were $7.2 billion, the most since the day after the Sept. 11, 2001, terrorist attacks on New York and Washington.

``You've got people showing up at the discount window, so easing that rate would do something,'' Marta said.

A cut in the Fed's target rate was expected by all but six of 134 economists polled by Bloomberg News, with 23 forecasting a half-point reduction.

Interest-rate futures show traders stepped up bets on rate cuts by the Fed as key market interest rates rose, reflecting investor unwillingness to provide financing for consumer and business loans. The first drop in U.S. employment in four years in August, announced by the Labor Department on Sept. 7, further boosted expectations the central bank would lower rates to avert a recession.

Fed Funds Futures

The yield on federal funds futures expiring in September, a forecast for the average rate during the month, dropped from 5.225 percent on Aug. 8 to 4.87 percent on Aug. 21. Before today's announcement it was 5 percent. Contracts expiring in January yielded 4.54 percent, pricing in additional rate cuts by the end of this year.

The three-month London interbank offered rate, a benchmark for banks' ability and willingess to extend credit to one another, rose to a six-year high of 5.725 percent on Sept. 7. Set by the British Bankers' Association, three-month Libor was 5.36 percent most days this year until Aug. 8, when it started to rise as banks curbed lending. It was set today at 5.59 percent.

Rising rates of default on home mortgages, especially subprime loans to the least creditworthy borrowers, triggered a flight by investors from debt backed by other types of consumer and business loans. The crisis deepened as short-term lenders to loan originators withdrew, creating a financing vacuum for banks to fill.

Commercial Paper

Asset-backed commercial paper, short-term debt sold to finance banks' off-balance-sheet holdings of loans and bonds, fell to $945.1 billion outstanding on Sept. 12 from a peak of $1.18 trillion on Aug. 8.

The discount rate on overnight asset-backed commercial paper rose as high as 6.20 percent in late August after averaging 5.27 percent this year through the end of July.

Two-year note yields will rise to 4.24 percent by year-end, a Bloomberg News survey of 68 economists shows, with the most recent forecasts given the heaviest weightings.