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Bonds Rally Amid Stock Sell-Off

Reuters
Tuesday, 22 Jan 2008 | 1:40 PM ET

U.S. Treasurys surged on Tuesday after an emergency interest rate cut by the Federal Reserve met with limited success in staunching a sell-off in stocks and helped extend a safe-haven bid for government debt.

The Fed's most aggressive reduction in the benchmark federal funds rate in 23 years did pull U.S. and European stocks out of the deep slide that has gripped equities globally this week, but the surprise move also fanned worries the economy's problems run deep.

U.S. benchmark stock indexes remained broadly lower, though well above their lows, while European stocks mustered a rally.

The Fed slashed its federal funds target rate by three-quarters of a percentage point to 3.50 percent, the lowest level since September 2005.

Tuesday's rate cut, a week before Fed policy-makers convene for a regularly scheduled meeting on Jan. 29-30, was eye-popping in the context of the Fed's usual gradualist approach.

But the Fed still needs to do more, traders and analysts said.

"The market is telling the Fed that they have to ease more," said Martin Mitchell, head of government trading at Stifel Nicolaus & Co in Baltimore.

The Fed's biggest easing in the funds rate since October 1984 occurred while U.S. Treasury Secretary Henry Paulson called for a government stimulus package, which some analysts dismissed as being too small to revive a deteriorating economy.

In fact, more Wall Street analysts are predicting a U.S. recession this year. UBS became the latest firm to forecast the U.S. economy would contract in the first half of the year.

Gloomy Outlook

The grim economic outlook, plus the market turmoil, spurred investors to seek highly liquid and low-risk assets.

The benchmark 10-year note pared early price gains but still traded up 21/32 for a 3.547 percent yield, versus 3.51 percent before the Fed's emergency rate cut and 3.63 percent late on Friday. Bond yields and prices move inversely.

Among shorter maturities, the two-year Treasury note was up 13/32 in price, its yield at 2.141 percent, down 21 basis points from late Friday.

The two-year yield fell briefly below 2 percent for the first time in nearly four years in overseas trading.

U.S. financial markets were closed on Monday for the Martin Luther King holiday.

The deepening market turmoil, which stemmed from the prolonged woes in the U.S. housing and mortgage markets, seemed to have forced Fed policy-makers to make their move before next week's scheduled meeting, to forestall further damage to the economy, analysts said.

Traders are betting the Fed will slash rates further to prevent the economy from going into a prolonged contraction.

U.S. interest rate futures implied traders see the Fed lowering the fed funds target by another half point at its Jan. 29-30 meeting.

Even if it helps in the short run, easier monetary policy now would hurt the economy in the long run by weakening the dollar and boosting inflation, said Haag Sherman, managing director at Salient Partners in Houston.

"Ultimately these rate cuts will be self-defeating," Sherman said. "They are going to prove inflationary and bad for the dollar."

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