TBO.com - TBO is Tampa Bay Online

History Points To Another Fed Rate Cut Before January

ADVERTISEMENT

By ELIZABETH STANTON, Bloomberg News

Published: September 25, 2007

Government bond traders, who predicted six of the past seven recessions, say the Federal Reserve will lower interest rates again before the end of the year as the economy comes to a standstill.

Since the Fed last week lopped half a percentage point off the central bank's target for overnight lending between banks - the first orchestrated decline in so-called federal funds since 2003 - traders have pushed the yield on Treasury two-year notes to almost three quarters of a point below the designated 4.75 percent funds rate.

In the three previous occasions in the past 20 years when that has happened, borrowing costs have been cut.

'The U.S. economy needs to grow at 2.5 to 3 percent or else it stalls,' said Bill Gross, manager of the $104.4 billion Total Return Fund, the world's biggest bond fund. 'Historically, every time we get close to stall speed the Fed lowers short rates.'

Concerns Shift

The latest government data show unexpected job losses in August, sagging core retail sales and no relief in sight for the moribund housing market. Now that U.S. gross domestic product probably is growing at an annualized rate of less than 2 percent, speculation is rampant that another Fed rate cut is assured before January.

'The market is anticipating there could be some further rate cuts down the line,' said James Sarni, senior managing partner at Payden & Rygel in Los Angeles, which manages $54 billion. 'There has been a shift in the balance of what's driving the Fed from concern about inflation to more concern about growth.'

At each of their 11 regular meetings from May 2006 until Aug. 7, policy makers said inflation was the main risk facing the economy. Last week they said only that 'some inflation risks remain.'

What changed for the Fed was the first drop in U.S. employment in four years in August, an unexpected decline in retail sales excluding automobiles, and the inability of borrowers to roll over short-term debt.

The Washington- based National Association of Realtors said last week the worst housing slump in at least 16 years will extend into 2008 as tighter loan standards cut home sales.

In 1989 a series of 23 rate cuts began in June and continued until September 1992, taking the fed funds rate to 3 percent from almost 9.75 percent. The last series of cuts began Jan. 3, 2001 and ended in June 2003. The rate dropped to 1 percent from 6.5 percent.

The economy has gone into recession seven times since 1960, and six were foreshadowed by yields on three-month Treasury bills exceeding yields on 10-year notes. Three-month yields, now 3.73 percent, exceeded 10-year yields from July 2006 through May 2007.

Some areas of the financial markets show that the Fed's cut may be working. U.S. stocks posted their biggest weekly advance since March, and the three-month London interbank offered rate has fallen to 5.20 percent from 5.725 percent on Sept. 7, indicating a resumption of lending by banks.

Not Always Accurate

Futures on the fed funds rate traded on the Chicago Board of Trade imply a 72 percent chance of a cut to 4.50 percent at the Fed's next meeting on Oct. 31, and 55 percent odds of a reduction to 4.25 percent at the Dec. 11 gathering. The chances of a 4 percent rate by the end of January are about 22 percent.

Interest-rate futures have an accuracy rate of less than 30 percent since 1994 in forecasting the fed funds target, an August 2006 study by the Federal Reserve Bank of St. Louis found. As recently as July 25, futures put the odds of a target lower than 5.25 percent by November at less than 20 percent.

This time, they may prove prescient, according to Lacy Hunt, chief economist at Austin, Texas-based Hoisington Investment Management Co., which oversees about $5 billion of Treasurys. The firm's Wasatch-Hoisington U.S. Treasury fund has returned an average of 4.5 percent a year over the past five years, more than any other actively managed long-maturity U.S. government bond fund, according to Morningstar.

The economy's mortgage-related problems are 'not behind us today and they're not going to be behind us for a long time to come,' Hunt said. 'This rate reduction was first of what we think will be quite a few over the next couple of years.'

Share this:

Loading Comments...

Email Print

ADVERTISEMENT