US Treasury debt prices surged in a scramble for safety stoked by investors' fears about the financial system following a fire sale deal for Bear Stearnsand a cut in the Federal Reserve's discount rate.
Short term inter-bank lending rates in Europe and the United States jumped, while the cost of insuring the debt of US banks against default rose, signaling market participants' growing fears of counterparty risk. Federal funds traded at 3.50 percent, an unusually wide 50 basis points above the target rate the Federal Reserve sets.
Two-year Treasury note yields, which move inversely to their prices, dropped earlier to about 1.25 percent, near five-year lows, as investors plowed into short-dated US government paper.
The rally in prices for Treasurys shows that investors "are expecting the Fed to continue to ease. There is a lot of concern that regardless of what the Fed does. Is it really going to help? Will it increase economic growth and cause financial institutions to start lending again and already over-indebted consumers to start borrowing again?" said Mary Ann Hurley, senior Treasurys trader in Seattle at brokerage D.A. Davidson.
On Sunday, the Federal Reserve cut its discount rate by 25 basis pointsto 3.25 percent and approved special financing to allow for the purchase of ailing investment bank Bear Stearns by JPMorgan Chase .
The Fed launched a new facility that would allow US primary dealers, which are mainly investment banks, to tap the discount window in a tool not used since the Great Depression.
"There is no risk appetite whatsoever. Treasury prices are sharply higher in a strong flight-to-quality trade," said T.J. Marta of Royal Bank of Canada Capital Markets in New York.
"Credit default swaps in the banking sector have blown out," Marta added.
The severity of the crisis, as highlighted by Sunday's events, sent shockwaves through Asian and European markets on Monday and boosted safe haven government bonds as investors feared another casualty after the Bear Stearns downfall.
In the background, data showing a bigger-than-expected fall in February U.S. industrial outputand weak New York State manufacturing added to mounting evidence of a potential US recession and helped Treasurys briefly extend price gains.
The benchmark 10-year Treasury note's price, which moves inversely to its yield, was up 1-2/32 for a yield of 3.34 percent, versus 3.47 percent late Friday.
Wall Street stocks fell on the banking sector worries, with the Dow Jones industrial average down about 0.8 percent at 11,846 points.
The multibillion-dollar question remained whether the Federal Reserve can prevent the financial crisis from worsening.
"There is a lot of anxiety this morning. Some fear we could see a broader panic spreading to other brokerage firms," said Scott Brown, chief economist with Raymond James & Associates in St Petersburg, Fla.
The 2-year Treasury note's price was up 8/32 for a yield of 1.36 percent, versus 1.49 percent late Friday.
The stampede into ultra short-dated US government paper sent one-month and three-month Treasury bill yields falling well below 1 percent to levels not seen in 50 years, reflecting just how scared market participants were.
"There is a flight to liquidity and safety with the recent financing woes that is driving T-bill rates down," said Matthew Moore, economic strategist with Banc of America Securities, N.Y.
Investors were also anxious about the balance sheets of investment banks, which report their first-quarter earnings this week.
Short-term interest rate futures were pricing in a small chance of a cut in the fed funds target rate totaling 125 basis points by the end of the Fed's policy meeting on Tuesday and fully pricing in 100 basis points of cuts to 2.0 percent.
Such a reduction in one fell swoop would be among the most aggressive cuts in the modern history of the Fed, on top of the central bank's array of initiatives to stem a liquidity squeeze that has ensnared the $7 trillion mortgage bond market.