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UPDATE 1-Once unthinkable, investors contemplate negative U.S. Treasury yields

Karen Brettell

yields@ (Updates Fed rate probability, prices throughout)

March 6 (Reuters) - A collapse in Treasury yields has led investors to start preparing for the possibility that some U.S. government interest rates could turn negative, as concerns about a spreading coronavirus drive a scurry for low-risk government debt.

The Federal Reserve on Tuesday made its first emergency cut since the financial crisis, dropping the federal funds rate by 50 basis points to the 1.0% to 1.25% band.

The move has not satisfied markets, however, with stock markets cratering and Treasury yields continuing to plunge to record lows. Interest rate futures traders are now pricing in a 50% probability that rates will be zero-bound by April, according to the CME Groups FedWatch Tool.

Even if the Fed is resistant to adopting negative rates, as most expect, Treasuries should hold their appeal as the worlds largest and most liquid market. That means that strong demand could send yields on some shorter-dated notes into negative territory, a move that seemed unthinkable only a few weeks ago.

Two-year Treasury yields dropped as low as 0.292% on Monday, the lowest since October 2014, when the fed funds rate was zero-bound. Benchmark 10-year notes yields plunged to a record low of 0.469%.

"Even if the Feds effective lower bound for fed funds is still positive, there is no reason that twos, fives, even potentially 10s, couldn't trade negative," said Jon Hill, an interest rate strategist at BMO Capital Markets in New York.

Yields on short-term Treasury bills have briefly traded negative in times of stress, but it would be unprecedented for short and intermediate-dated notes to do the same. A negative yield means investors would pay the U.S. government to hold the debt.

The Fed is reluctant to cut rates into negative territory as it risks disrupting the large U.S. money market sector. There are also questions over whether negative rates have been successful at stimulating growth in other countries.

"We have a very, very large money market complex," said Subadra Rajappa, head of U.S. interest rate strategy at Societe Generale in New York. "The Fed has resisted taking interest rates to negative territory because they dont want to disrupt the liquidity in the financial system."

On Friday, Boston Fed President Eric Rosengren said if yields drop to zero, the Federal Reserve should consider buying a broader range of assets.

"That would be a game-changer in my opinion, as no one in their right mind would want to be short an index when against a central bank with unlimited funds," said Chris Weston, head of research at Australian brokerage Pepperstone.

"It seems the bond vigilantes are out to get the Fed to go hard here."

Economic growth overseas has been far more sluggish than in the United States. The European Central Bank introduced negative interest rates in 2014 and the Bank of Japan followed in 2016. Two-year notes in Germany and Japan currently yield -0.86% and -0.31%, respectively.

If longer-dated U.S. Treasury yields are hovering near zero, some see a risk that a new wave of buying could turn shorter-dated ones negative.

"The one thing about the Treasury market that makes it so attractive, regardless of the price is the liquidity and the depth of the market," said Michael Lorizio, senior fixed income trader at Manulife Asset Management.

If longer-dated yields continue to drop then, "the front-end in that scenario would be under significant pressure to maintain the positive yield," he added.

The current bond rally is notable because investors are preparing not only for zero-bound rates, but a raft of additional measures, including quantitative easing, as the Fed battles an economic slowdown. That adds to anticipation that future yield moves may also be unprecedented.

"This is the first time were cutting back to zero with a full-blown expectation that QE will soon follow," said Hill. "Were at an extremely fragile state right now in the global economy." (Reporting by Karen Brettell; Additional reporting by Vidya Ranganathan; Editing by Alden Bentley and Clarence Fernandez)