Bonds close higher on quarter-point Fed cut

NEW YORK (CNNMoney.com) -- Treasury prices rallied Tuesday after the Federal Reserve lowered the federal funds and discount rates while sending a vague signal that more rate cuts are an option.

The Fed lowered its fed funds overnight target by 0.25 percentage point to 4.25 percent and also reduced the discount rate, which is charged to commercial banks that borrow directly from the central bank, by 0.25 percentage point to 4.75 percent.

The action was broadly in line with market expectations, given that the credit markets have been fragile and in need of stimulation due to the continuing impact from defaults on low-quality mortgage assets.

Some investors had expected a heftier 0.50 percentage point cut in the rates. Still, bond investors were pleased to see the bank cheapen the price of money because that will stimulate the troubled credit markets. However, stock prices plummeted after the announcement because many equity investors had thought a bigger cut was a near certainty.

The Fed's monetary policy statement made clear that the central bank is concerned about both increasing economic uncertainty and the pace of inflation. The Fed removed a statement that was included in the prior communiques stating that risks to the economy are balanced. Yet it made clear that it would monitor inflation carefully.

"Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending," the Fed policy-makers wrote.

"Moreover, strains in financial markets have increased in recent weeks. Today's action, combined with the policy actions taken earlier, should help promote moderate growth over time."

The fact that the central bank is concerned about weak growth indicates more rate cuts are possible in 2008. Yet the Fed's suggestion that the three rate cuts seen in late 2007 will suffice makes those prospects seem remote.

Rich Berg, chief executive officer of Performance Trust Capital Partners, described the Fed statement as "lukewarm."

"All the Fed is really doing is saying that it is paying attention to your pain and that it will keep moving along until it is less painful," Berg said. "This looks like a way to buy more time and hope that the financial system will work out its own kinks."

The price on the benchmark 10-year Treasury note rose 1 7/32 to 102 1/32 with a yield of 4.00 percent, down from 4.16 percent late Monday. Prices and yields move in opposite directions.

The 30-year long bond gained 2 2/32 to 108 9/32 with a yield of 4.49 percent, down from 4.62 percent Monday.

The 2-year note gained 12/32 to 100 9/32 with a yield of 2.97 percent, down from 3.18 percent.

The 3-month yield dropped to 2.94 percent from 3.04 percent as the discount rate fell to 2.88 percent from 2.97 percent.

Additional buying in after-hours trade sent yields lower. The benchmark 10-year yield fell to 3.97 percent as the 30-year yield fell to 4.47 percent and the 2-year yield dropped to 2.92 percent. The 3-month note yield fell to 2.92 percent and the discount rate fell to 2.85 percent.

Joe Brusuelas, chief U.S. economist at IDEAGlobal.com, said bond market investors also responded well to the fact that the Fed statement emphasized that growth is weak. Bonds perform well in periods of economic softness.

New revelations from savings and loan Washington Mutual Inc. and H&R Block Inc., the nation's largest tax preparer, underscored the fact that the contagion from subprime mortgage problems has not been contained.

These developments bolstered expectations for a rate reduction and helped stir demand for Treasurys. Throughout the subprime crisis, demand for the security of Treasurys has been strong as these bonds carry a government guarantee while other portions of the credit market are riskier.

H&R Block (Charts, Fortune 500) Tuesday reported a bigger-than-expected quarterly loss after shutting down its Option One Mortgage subprime lender. The company will realign its costs structure because it will be a smaller entity without the subprime lending unit.

Washington Mutual (Charts, Fortune 500), a major mortgage lender, late Monday said it will exit the subprime business and slash about 3,150 jobs from its payrolls. The savings and loan also will close offices, lay off more than 3,000 workers, slash its dividend, and set aside up to $1.6 billion for loan losses in the fourth quarter.