Bonds mixed after Fed cuts interest rate

Treasurys give up earlier gains after the central bank cuts its key lending rate to juice an economy in crisis.

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By David Goldman, CNNMoney.com staff writer

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NEW YORK (CNNMoney.com) -- U.S. Treasurys gave up earlier gains Wednesday and were mixed after the Federal Reserve cut its key lending interest rate by half a percent.

The Fed lowered its key funds rate to 1% at the conclusion of its two-day meeting. With the U.S. economy embroiled in a dire and expensive credit crisis, some had even predicted a cut to 0.75%, which would have marked the lowest level for the fed funds rate in its 53-year history.

But for most market watchers, the news was expected. "I don't think it was a big surprise," said Andrew Brenner, senior vice president at MF Global.

The Fed cuts rates to boost the economy. Treasurys typically sell off when rate cuts are expected, as they tend to be inflationary, but bond prices were higher throughout the session. With commodity prices plummeting and a sluggish economy, inflation fears have somewhat subsided.

The benchmark 10-year note reversed course to drop 6/32 to 101-5/32, and its yield rose to 3.86% from 3.84% late Tuesday. Bond prices and yields move in opposite directions.

The 30-year bond sunk 22/32 to 104 19/32, and its yield rose to 4.23%, from 4.21%.

The 2-year note was still up 7/32 to 99-29/32, and its yield fell to 1.56% from 1.66% late Tuesday.

In order to finance the trillions of dollars in financial bailouts and corporate debt purchases, the Treasury auctioned off $34 billion in 2-year notes Tuesday, and will auction $24 billion in 5-year notes on Thursday.

"With all of the government programs going on, Treasurys are looking ahead to the more than $3 trillion in debt to be issued this year," said Brenner.

With such a massive supply heading to market to fund rescue measures, "it will be difficult for Treasurys to rally," added Brenner.

The yield on the 3-month bill fell to 0.61% from 0.74% on Tuesday as the price ticked higher.

The yield on the 3-month Treasury bill is closely watched as an immediate reading on investor confidence. Investors and money-market funds shuffle money into and out of the 3-month bill frequently, as they assess risk in the rest of the marketplace. A higher yield indicates that investors are slightly more optimistic.

Treasurys were much lower Tuesday as global stocks reversed their recent downward trend and a late day rally on Wall Street sent the Dow surging 889 points.

Signs of improvement

Many economists called for the Fed to cut rates to historic lows, because lending to and from financial institutions remains tight. But early indications show the Fed's other attempts to ease financing concerns for financial institutions were working.

In the Fed's statement released with the interest rate cut announcement, it said that efforts by the it and other central banks should work to ease the tightened credit markets.

"Recent policy actions, including today's rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth," the statement said.

This week, the Fed's effort to boost short-term financing concerns for companies was reflected in a record amount of commercial paper issued.

The Fed said commercial paper issued Tuesday with maturities of more than 80 days stood at $41.6 billion. On Monday, there was $67.1 billion of long-term paper issued, making this week's total nearly $109 billion. That's up significantly from $7.4 billion on Friday and $3.6 billion on Thursday. Monday saw the largest amount of long-term corporate debt purchased in one day since the Fed began maintaining records in 2001.

Commercial paper is short-term debt that big businesses and financial institutions sell primarily to money-market fund managers and other institutional investors. The companies use the loans to fund day-to-day business operations, but the market dried up, particularly for three-month paper, after the collapse of Lehman Brothers in mid-September.

Lending rates fall

The Fed is offering competitive rates in its commercial paper program. Many analysts, including Bill Gross, the chief investment officer for Pimco, have said the Fed's offer of low 3-month commercial paper rates will help nudge other rates lower, including 3-month Libor rates. That would be a major boost for the strangled credit market, as more than $350 trillion is assets are tied to Libor.

"The commercial paper facility is going to bring Libor down, which has been a little slow coming down recently," Brenner said. "The Fed has allowed people to buy more aggressive paper, giving them flexibility to buy whatever they want. It's a very positive program."

Accordingly, the 3-month Libor rate nudged lower to 3.42% from 3.47% on Tuesday, and the overnight Libor rate fell for the third-straight day to 1.14% from 1.24% on Tuesday, according to Dow Jones.

Lending rates have been trending downward for nearly two weeks. Libor is a daily average of what 16 different banks charge other banks to lend money in London.

But even as rates fell, two key indicators of risk sentiment showed that confidence in the market wasn't improving.

After the Fed cut rates, The Libor-OIS spread increased to 2.65 from 2.61 points Tuesday. The spread measures how much cash is available for lending between banks, and is used for determining lending rates. The bigger the spread, the less cash is available for lending.

Another indicator, the "TED spread," rose to 2.81 percentage points from 2.71 points on Tuesday. The TED spread measures the difference between the 3-month Libor and the 3-month Treasury bill, and is a key indicator of risk. The higher the spread, the less willing investors are to take risks.  To top of page

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