Bonds Surge Rate Cut Bets, Declining Stocks

U.S. Treasuries surged Monday, driving short-dated yields to two-year lows, as traders bet the Federal Reserve would aggressively cut interest rates next week and stocks eased on housing-related worries.

Government bond prices extended Friday's hefty gains triggered by an unexpected drop in nonfarm payrolls, with the 30-year bond rallying more than a full point.

August's jobs report left traders certain the Fed would cut the benchmark overnight lending rate at its Sept. 18 meeting, with a growing chorus now expecting the federal funds rate target to be lowered by 50 basis points to 4.75 percent.

"People are coming to the view that ... perhaps 50 basis points is not out of the question," said Wan-Chong Kung, senior fixed income portfolio manager at First American Funds in Minneapolis.

Benchmark 10-year notes traded 18/32 higher in price for a yield of 4.31 percent, versus 4.39 percent late on Friday. Yields, which move inversely to prices fell as far as 4.30 percent, their lowest since early 2006.

Two-year notes, the most sensitive to changing views on Fed interest rate policy, rose 4/32 to yield 3.84 percent. Yields earlier dropped to 3.82 percent, their lowest since late 2005.

Two-year yields have fallen nearly 75 basis points since the end of July.

Speeches by Fed officials did little to alter the market's view of an interest rate cut next week and more easing until mid-2008. That, combined with the drop in equities kept the Treasury market well bid.

"Beyond next week's meeting, the cumulative ease that the market is pricing in is closer to 125 basis points through mid next year. That certainly has been a big part of the story," said Kung.

"Previously the thinking was the Fed might have to do a couple (of rate cuts) to calm the financial markets turmoil, but with the very dismal nonfarm payrolls print, there is evidence the real economy is suffering and the Fed needs to be more fully engaged."

San Francisco Federal Reserve Bank President Janet Yellen said the current financial market turmoil had added "appreciably" to downside risks for the U.S. economy.

The 30-year bond rose 1-5/32 in price, and yields tumbled as far as 4.62 percent, their lowest since March. Five year notes jumped 9/32 in price, pushing yields down as far as 3.96 percent, a two-year low.

The stock market remained weighed down by concerns over housing and general worries about the economic outlook. Reminding investors of housing's problems, Washington Mutual , the largest U.S. savings and loan, may set aside $500 million more than it had previously forecast for loan losses in 2007, amid what Chief Executive Kerry Killinger on Monday called a "near perfect storm" in the troubled sector.