Treasurys Stall After Initial Surge

Treasurys gave back much of a vigorous rally in late trading Wednesday when a sagging stock market suddenly regained strength and stopped the flow of money into bonds.

The volatile price swings typify the uncertainty that has swept the markets in recent weeks as investors grapple with sudden developments in the economic and interest rate outlooks.

Earlier in the session, Treasurys rallied forcefully, causing the 2-year yield to plunge to a four-year low as it mirrored investors' belief that the Federal Reserve has embarked on a rate cutting spree.

The frenetic session also saw the yield on the 30-year bond hit its lowest point ever as it skidded below the 4.15 percent it held when first issued in 1977.

Bond Yields

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The initial rally was part of an advance that began Tuesday after the Fed lowered the benchmark fed funds target by a sizable 0.75 percentage point to 3.5 percent. The Fed is holding a regularly scheduled monetary policy meeting next Tuesday and Wednesday.

"The perception is that the Fed will have to reduce rates by another 0.50 percentage point on Jan. 30," said Tom di Galoma, head of Treasurys trading at Jefferies & Co. Although bond market investors remain convinced they will see more rate cuts next week, the late afternoon surge of demand for stocks lessened demand for safe assets.

The 2-year yield closed off its highs, rising 1/32 to 102 11/32 with a yield of 1.98 percent, down from 1.99 percent in late trade on Tuesday. Earlier, the yield fell as low as 1.85 percent, its lowest since February 2004.

The benchmark 10-year note gave back all its gains to close down 3/32 at 106 25/32 with a yield of 3.43 percent, down from 3.41 percent late Tuesday. At the height of Wednesday's rallly, the yield sank to its weakest point since June 2003.

The 30-year long bond rose 5/32 to 113 26/32 with a 4.18 percent yield, down from 4.20 percent late Turesday. During the session the long bond's yield sank to a record low of 4.13 percent yield, placing it below its 1977 debut at 4.15 percent yield.

Recent rallies have pushed the yield on the 2-year note, which is the most sensitive to interest rate policy, sharply lower to reflect investors' belief that the Fed has no option but to cut rates again next week to stimulate battered credit markets and a faltering economy. Prices and yields move in opposite directions

Traders study the spread, or distance, between the Fed funds rate and the 2-year yield for clues as to the direction of official rates.

On Wednesday, the difference between the 2-year yield and the Fed funds target was as large as 1.64 percentage points. Generally the yield and the target rate trade within 0.25 percentage point of each other. The gaping difference between the two rates is a classic signal investors expect rate cuts and also puts pressure on the Fed to make those reductions.

At the start of the credit market crisis in August 2007, the Fed sought to avoid reacting directly to turbulent financial markets and tried to hinge monetary policy mainly on economic data. But huge losses on Wall Street this year appear to have played a part in the Fed's move this week. The Fed met in emergency session to authorize the latest rate reduction Monday, when global stock exchanges suffered massive selling routs and Wall Street was closed for a holiday.

There is now a sense that the stock and bond markets are helping guide Fed policy, according to Alan Tedford, a fixed-income portfolio manager at Stephens capital Management.

"The Fed has a lot more work to do," he said. Investors are wrangling to see the fed funds rate below all major Treasury yields, he said noting that the 10-year yield also is below the 3.5 percent Fed funds target.

"The Fed has got to get the fed funds rate to where banks can lend again," he said. "Right now, it costs banks more to borrow than to lend." The fed funds target is the rate the Fed charges on its 24-hour commercial loans to banks.

The demand for Treasurys also reflects increased investor demand for safe assets after a number of prominent economists have speculated that the economy has entered a recession. However, a recession consists of two consecutive quarters of economic contraction and can only be declared after the fact.