Bond Yields Soar on Rate Cut
Long-term bond yields soared Wednesday as investors registered their disappointment with the Federal Reserve’s quarter-point cut in its key interest rate.
Though the bond market clearly was hoping for more, the stock market’s response was mixed. Major indexes declined, with the Dow industrials sliding 98.32 points, or 1.1%, to 9,011.53. But more shares rose than fell on the New York Stock Exchange and on Nasdaq.
More important than the day’s action was that the central bank set the stage for a debate that may dominate Wall Street this summer: If the economy picks up, and the end of interest rate cuts is here or near, what are the proper levels for bond yields and stock prices?
The Fed, in reducing its benchmark rate to 1% from 1.25%, appeared to leave the door open for further declines. But some bond investors decided that the Fed’s reluctance to cut a half-point indicated that policymakers are more certain of an economic turnaround sooner than later, which could mean that the next significant move in interest rates would be up.
Rather than wait around for more evidence of a better economy, some investors dumped bonds, sending yields rocketing. The yield on the 10-year Treasury note, a benchmark for mortgages, jumped to 3.4% from 3.25% on Tuesday. It was the biggest one-day reversal in the yield in three months and left it at its highest level since June 2.
“The bond market rally is over,” said Peter Boockvar, investment strategist at Miller, Tabak & Co. in New York. The Fed on Wednesday said “that’s it,” he believes.
Investors have heard that warning before, however, and it has been premature.
The central bank has guided interest rates to generational lows over the last 2 1/2 years as the economy has struggled. As the Fed slashed short-term rates, the 10-year T-note fell to 5.05% by the end of 2001 and 3.82% by the end of last year.
In recent months, Fed officials have stoked expectations for further rate cuts by warning that the economy could be vulnerable to deflation -- a broad-based decline in prices.
That talk fueled another plunge in bond yields this spring, driving the 10-year T-note to a 45-year low of 3.11% on June 13.
But some analysts believe the Fed overstated the case for deflation and, in the process, left many bond investors convinced that Wednesday’s rate move would be a half-point cut.
With recent economic data appearing more upbeat, “the Fed found it had put itself in a box and had to find a way out,” said Joseph Carson, economist at Alliance Capital in New York.
The Fed had to give bond investors at least a quarter-point cut, Carson said, even though he believes policymakers could have justified leaving rates unchanged.
The central bank was careful in its statement Wednesday to say that “recent signs point to a firming in spending, markedly improved financial conditions, and labor and product markets that are stabilizing.” But it also said that the economy still “has yet to exhibit sustainable growth.”
For stock investors who have bid share prices higher over the last three months, a reviving economy may be exactly what they’ve had in mind. Faster growth would be expected to boost corporate earnings, making stocks more attractive.
But what’s good for stocks often is bad for bonds: If the economic outlook continues to improve, more investors probably would dump fixed-income securities, figuring that the Fed eventually will tighten credit.
“The bond market is going to go through a period of playing out the possibility that the recovery is for real,” said Vic Thompson, head of fixed-income investments for State Street Global Advisors in Boston.
Interest rate whiplash in the bond market could be exacerbated by the large number of short-term traders who have piled into bonds this year with the intent of riding the trend only until it reverses, analysts say. Some have likened the rally in bonds to the Internet stock bubble of the late 1990s.
If bonds continue to sell off, the question for the stock market becomes, how high could yields rise before they would halt stocks’ rally?
Experts note that, historically, share prices often have continued to rise even after interest rates have begun to turn up amid an economic recovery.
“I’m not sure that a spike in yields would freak the stock market out,” said Jack Ablin, chief investment officer at Harris Trust & Savings Bank in Chicago.
As a stock investor, “I would actually take comfort in” rising yields, he said, if the reason for the rise was stronger economic growth.
That sentiment may have helped to support prices of many stocks Wednesday, though the market overall gave up early gains after the Fed’s announcement sent the bond market reeling.
Most major market indexes fell less than the Dow. The Standard & Poor’s 500 index dipped 8.13 points, or 0.8%, to 975.32. The Nasdaq composite eased 2.95 points, or 0.2%, to 1,602.66.
Rising stocks outnumbered losers by 18 to 15 on the NYSE and 17 to 15 on Nasdaq. Trading volume was moderate.
Some analysts say worries about a lasting surge in bond yields may be misguided. Fed officials in recent months have made clear that they will keep short-term rates depressed for a long period, perhaps well into 2004.
They also have hinted that they could take action to directly push long-term yields down by using Fed capital to buy bonds in the market place.
Many experts say that such a move would be a major departure for the Fed, and inherently risky. But the central bank might not have to do more than raise the issue to keep bond investors excited about the possibility of a continuing rally, Thompson said.
“Even talking about it could have the desired effect,” he said.
What’s more, there remains the chance that the economy will weaken instead of strengthening in the next few months, which could trigger a new round of rate cuts by the Fed, Thompson and others say.
Likening the economy to a sick man, Thompson said the Fed has done a good job keeping the patient reasonably comfortable since 2000. “But is he going to get out of bed?”
Among Wednesday’s market highlights:
* Shorter-term Treasury yields soared with longer-term yields. The two-year T-note yield jumped to 1.28% from 1.1% on Tuesday. At midday, before the Fed’s announcement, the government sold $25 billion of new two-year notes at a yield of 1.18%.
* Bank stocks, which are sensitive to changes in interest rates, were mixed. Citigroup lost 37 cents to $43.05, and Wells Fargo slipped 28 cents to $50.67. But Bank of America rose $1.10 to $78.65 after saying it raised its quarterly cash dividend 25% to 80 cents a share. BofA said it was motivated in part by the recent reduction in federal tax rates on dividend income.
* Money manager Neuberger Berman soared $3.17 to $37.60 on rumors that brokerage Lehman Bros. planned to bid for the firm. The talks were first reported on the Financial Times’ Web site. Both companies declined to comment. Lehman shares lost 76 cents to $69.48.
* Shares of two real estate investment trusts began trading on the NYSE after their initial public offerings Tuesday. Maguire Properties of Los Angeles closed unchanged at its IPO price of $19, but Jenkintown, Pa.-based American Financial Realty gained $1.75 to $14.25.
Market Roundup, C5-6
