Bonds Gain as Stocks Sink and Fears Fade Over Rate Hike

U.S. Treasurys rose Wednesday as widening stock market losses enhanced the bid for safe-haven government debt and made a Federal Reserve rate hike this summer look less likely.

Stocks fell after Morgan Stanley said its earnings dropped by more than halfand Fifth Third Bancorp announced a dividend cut and a plan to raise capital.

The losses in bank shares helped bond prices because weakness in the credit and lending system would make the Fed less likely to withdraw liquidity from the banking system by tightening monetary policy.

"The perception is that the Fed can't raise rates, the way the market was thinking they were going to do, mainly because of problems with some very notable regional banks which are trading at their 52-week lows," said Thomas di Galoma, head of U.S. Treasurys at Jefferies & Co in New York. "The Fed doesn't want to cause any further problems by raising rates."

Benchmark 10-year Treasury notes Wednesday traded 7/32 higher in price, their yields easing to 4.17 percent from 4.21 percent Tuesday.

Two-year notes, which are especially sensitive to shifting perceptions on Fed monetary policy, edged up 1/32 in price, with their yields easing to 2.87 percent from 2.91 percent Tuesday.

Last week, yields on two-year notes posted their sharpest weekly rise in 26 years as anti-inflation talk from the Fed and other central banks persuaded investors that the Fed could raise rates two or three times before the end of the year.

Mortgage Applications Decline

But with the health of banks' balance sheets so intertwined with the mortgage crisis, an 8.7 percent drop in mortgage applications last week as reported by the Mortgage Bankers Association on Wednesday provided further evidence against rate hikes.

Mortgage rates have surged in June as Treasury yields have risen on hawkish inflation talk, weakening one of the few supports for the struggling U.S. housing market.

The "rather large drop in mortgage applications ... due to higher mortgage rates (seemed) to suggest the housing market would be hurt further by Fed tightening and so the Fed should hold off," said Matthew Moore, economic strategist with Banc of America Securities in New York.

The "slow-growth" economy will also make it hard for the Fed to raise interest rates, di Galoma said.

Futures contracts implied a 48 percent chance of an August Fed rate hike, down from 58 percent on Tuesday. A rate hike by September was still fully priced in and the projected year-end federal funds rate stood at 2.68 percent, down from a projected rate of 2.83 percent at end of last week. The rate currently stands at 2 percent.

Di Galoma said market positions were also "a lot thinner than they've been in weeks.

"People got forced out of trades when the curve flattened so much," he said. "Two-year yields were at 3.10 percent just the other day," he said, referring to the sharp drop in short-term yields since last week.