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Investor Appetite for Bonds in a Tepid Recovery Weighs on Rates

Just how low can interest rates go?

Rates keep falling, and Wall Street increasingly seems convinced that they will stay low for years. But it isn’t the Federal Reserve that is cutting them — it is the bond market. The weak-kneed economy has investors piling into United States Treasury securities, driving prices up and yields down.

The stampede into bonds is lowering the rates on things as diverse as home mortgages and corporate loans. The two-year Treasury rate sank to a record low on Friday, briefly edging below 0.5 percent. Thirty-year fixed-rate mortgages have fallen below 4.5 percent — another record. And, with clouds gathering over the economic recovery, the Fed is expected to hold its benchmark rate near zero this week.

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

All of this is good news for people borrowing money, but bad for those saving it in bank accounts and money market funds. The average one-year certificate of deposit now pays 1.3 percent a year. Such meager returns are particularly painful for people living on fixed incomes.

But rates are unlikely to turn higher soon, economists say. In fact, they could fall even further. While the Fed cannot lower its official federal funds rate much more — that rate has been stuck at 0.25 percent all year — it can ease credit in other ways.

On Wall Street, a consensus is forming that the Fed might take less conventional steps, like buying more Treasury securities, to push market rates lower still.

Ward McCarthy, the chief financial economist at Jefferies & Company and a longtime Fed watcher, said he expected the Fed to formally acknowledge that, in the words of its chairman, Ben S. Bernanke, the outlook for the economy is now “unusually uncertain.” Given the glum outlook, the Fed will probably take other steps to ease credit, like reinvesting proceeds from its holdings of mortgage bonds and Treasuries into short-term Treasuries, Mr. McCarthy said in an e-mail.

Market rates have already dropped precipitously this year. The 10-year Treasury yield — a benchmark for a wide range of loans and one of the most closely watched rates in the world — has fallen by more than a full percentage point since early April. It dropped further on Friday, to 2.82 percent, as disappointing news on employment added to the worries about the economy. The rate is still above the 2.06 percent nadir touched in December 2008, in the depths of the financial storm.

William H. Gross, a managing director at Pimco, the giant bond fund manager, said the jobs report strengthened his argument that the economy and the job market would remain weak for the next few years. He calls his unhappy situation “the new normal” for the American economy.

“Currently, financial markets have accepted this thesis, the best evidence of which is the two-year Treasury yield at 0.50 percent,” Mr. Gross said in an e-mail. “If investors expected the Fed to raise rates at any time in the next two years, the yield would be much higher.”

Like Mr. McCarthy, Mr. Gross expects the federal policy makers to consider other steps, besides lowering rates directly, to try to revive growth. The Fed, for its part, will probably keep the fed funds rate at 0.25 percent for two to three years, he said.

Goldman Sachs economists said in a research note on Friday that they, too, think the Fed will respond to the weak jobs market with another round of unconventional easing. “These measures could involve more asset purchases — probably Treasury securities,” the economists wrote. Those purchases could total at least $1 trillion, they said.

Lower and lower rates may eventually encourage corporations to invest the big stockpiles of cash in plants and equipment. That, in turn, could lead to new jobs. But if companies instead sit on their hands, waiting for sure signs of an economic revival, basement-level rates may not do much to spur the economy. The latter, Mr. Gross said, amounts to “waiting for an economic Godot.”

But even if companies do not regain their nerve, bond investors will profit, since bond prices will keep climbing.

The bond crowd has done much better than stock investors lately. Since early May, the price of 10-year Treasuries has jumped about 6 percent. The Standard & Poor’s 500-stock index, by contrast, has fallen about 4.3 percent in that time.

Nariman Behravesh, the chief economist at IHS Global Insight, said the Fed would probably hold off raising rates until late next year. And if the economy deteriorated further, it might hold off until early 2012, he said.

“It is going to be quite some time before the Fed starts to tighten in any meaningful way,” he said.

But what is bad news for savers is good news for borrowers, especially potential home buyers. A big hope is that low rates will eventually stimulate the housing market. And midsize and large companies, or at least the creditworthy ones, can borrow money at attractive rates in the corporate bond market, as well as from banks.

“Once we get through the foreclosure mess, housing could come back quite strongly,” Mr. Behravesh said. “There is a huge pent-up demand for housing.”

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