Bond Prices Soar as Fed Rate Cut Seen

U.S. government debt prices soared Friday, sending short-dated yields to two-year lows, after surprisingly weak jobs data stoked recession fears and raised expectations for a Federal Reserve interest rate cut.

News that the nation's payrolls shrank for the first time in four years in August seemed to offer evidence that the U.S. housing market slump had caused the labor market to weaken, a key development for investors and monetary policy-makers.

"It's lights out for the economy; the Fed can't sit on their hands any longer," said Chris Rupkey, senior financial economist at Bank of Tokyo/Mitsubishi UFJ.

Two-year notes, which respond closely to expectations on Fed rate moves, rose 11/32 for a yield of 3.91 percent, a two-year low and down from 4.10 percent late Thursday. Bond yields and prices move inversely.

The benchmark 10-year note's price jumped 1-5/32 for a yield of 4.37 percent, the lowest since January 2006 and down from 4.52 percent late Thursday.

William Sullivan, chief economist at JVB Financial Group in Boca Raton, Florida, said the weaker-than-expected jobs numbers would prompt the Fed to lower the target for its benchmark federal funds rate at its next policy meeting Sept. 18.

He said the only question is whether the Fed will cut the rate by a quarter- or a half-percentage point. The current target rate is 5.25 percent.

"The much weaker payroll numbers in August validate current [Treasury market] yield levels," Sullivan said.

Pre-Meeting Rate Cut?

Some analysts argued that the Fed could cut interest rates even before its September policy gathering.

"Don't leave your desk from now through next Tuesday," Rupkey said. The Fed could cut its funds rate 25 basis points Tuesday and "give guidance" that a further cut was probable at the formal policy meeting, he said.

But Ward McCarthy, economist and managing director at Stone and McCarthy Research Associates, said it was "highly unlikely" that the Fed would cut interest rates before Sept. 18.

"Even if there was some kind of market disruption, as we had in August, they would deal with it the way they dealt with it then," McCarthy said, referring to the large, temporary additions of reserves to the banking system made last month by central banks, including the Fed.

"The Fed will decide to ease at the Sept. 18 FOMC (Federal Open Market Committee) meeting, but I'll be surprised if the policy statement provides any hint of what they'll do going forward," McCarthy said. "They'll continue to take it one step at a time."

McCarthy said Fed policy-makers have been reluctant to ease monetary conditions at all, on the premise that investors who take undue risks should pay the penalty if the risk goes bad.

"We're at a point now where the risks to the economy supersede the concern about moral hazard," McCarthy said. "Still, the Fed will continue to make policy decisions on a meeting-to-meeting basis."

The weak jobs data also prompted a rise in U.S. short-term interest rate futures, which showed the implied chance of a cut in the federal funds rate by half a percentage point this month rose to 72 percent from 42 percent late Thursday.

Stock market losses bolstered demand for high-quality U.S. government debt. The Dow Jones industrial average fell 250 points, or 1.87 percent, to 13,113 on Friday.

The U.S. August payrolls report showed a fall of 4,000 non-farm jobs, far below Wall Street's forecasts.

"Over the past three months, the economy has generated only 44,000 new jobs per month, down sharply from earlier in the year, and (job creation) will continue to decelerate because the subprime- and secondary credit-related problems are, indeed, taking a toll on the economy," McCarthy said.