Bonds Rally as Fears Persist Over Banking Industry

Treasury debt prices rallied Monday as concern about the U.S. banking sector pulled stocks back underwater, reviving the safety bid for Treasurys and arguing against tighter monetary policy.

Increased fears about the banking system overshadowed the government's proposed rescue plan for mortgage finance companies Fannie Mae and Freddie Mac, announced late Sunday, and whetted investors' appetite for safe-haven U.S. government securities.

On Friday, IndyMac Bank suffered a run on its deposits, resulting in the third-largest bank failure in U.S. history.

On Monday, shares of National City, which fell 27 percent in morning trade, were halted so the bank could announce that its depositors and creditors were not engaging in any unusual activity. National City said that as of Friday's close, it had $12 billion in excess short-term funds to meet obligations and it had one of the highest levels of capital among large banks relative to its assets.

"The (financial sector) crisis has not been resolved: there are clearly more shoes to drop," said John Canavan, market analyst at Stone & McCarthy in Princeton, N.J. "That means a significant, continued safe-haven bid for Treasurys."

The Treasurys rally partially reversed Friday's sell-off, which occurred after The New York Times said officials were mulling a plan to back the government-sponsored mortgage giants if their problems worsened and Reuters reported that the GSEs would be able to take advantage of the Federal Reserve's emergency discount window for short-term lending.

The cost of insuring U.S. Treasury debt against default rose on the plan to back Fannie and Freddie, according to data from CMA DataVision.

The benchmark 10-year Treasury note's price, which moves inversely to its yield, rose 26/32, its yield falling to 3.88 percent from 3.97 percent Friday when it rose 17 basis points from the previous day's close.

Two-year notes climbed 7/32, their yields easing to 2.54 percent from 2.62 percent on Friday.

"Treasurys are still a safe-haven security and it looks like the systemic risks are back; if they are, then you buy Treasurys," said Chris Rupkey, chief financial economist at Bank of Tokyo/Mitsubishi in New York.

The continued challenges to the financial system also made it much less likely that the Federal Reserve would raise interest rates any time soon, keeping the cost of financing investment positions steady.

"That's attractive for Treasurys because it means you have positive carry across the curve," said William Sullivan, chief economist at JVB Financial Group in Boca Raton, Fla.

Short-term interest rate futures see a negligible chance of a Fed rate hike in August and a rate hike is no longer fully priced in until the December meeting of the Fed's Federal Open Market Committee. As recently as Friday futures had strongly pointed to an October rate increase.

"The rescue (of Fannie Mae and Freddie Mac) just underscores how serious the credit market stresses are and we may be rebuilding a renewed preference for safety and liquidity," Sullivan said.

News of a plan to strengthen Fannie Maeand Freddie Mac briefly damped the safety bid for Treasurys in early dealings on Monday. It also prompted some selling of Treasurys in favor of agencies, narrowing the difference between Treasury and agency yields.

One aspect of the plan will give Fannie Mae and Freddie Mac access to the Federal Reserve's discount window, one of the ways that the Fed can lend money to major money center banks and investment firms on a short-term basis.