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November 1, 2001
Wall Street Stunned by Treasury's Action on Long-Term Bonds
By GRETCHEN MORGENSON
With fears mounting that nine interest rate cuts in almost as many months
may not be enough to rev up the United States economy, the Treasury
Department added some high-test yesterday to the Federal Reserve's fuel mix.
Unfortunately, Wall Street got run over in the process.
Treasury officials said that their decision to halt the issuance of 30-year
bonds was intended to save the government money. But traders scoffed at that
explanation, viewing the move as an almost desperate effort to push down
long-term interest rates, which had remained stubbornly high, and prod both
corporate and individual borrowers to spend again.
"Without a doubt the thing that the Fed really wants to do is get mortgage
rates and corporate rates down," said Peter McTeague, government bond market
strategist at Greenwich Capital Markets, a brokerage firm in Greenwich,
Conn. "But mortgage rates weren't falling as much as people hoped because
they are more driven by the long end of the yield curve. So they're trying
every little trick in the basket. If the Fed funds rate isn't going to do
it, let's see if we can do something else."
The predicament for the Fed has been that even as it slashed interest rates
from 6.5 percent at the beginning of the year to 2.5 percent last month,
longer-term borrowing costs for corporations and individuals had not fallen
as hard. For example, yields on the 10-year note, the benchmark for many
mortgage rates and corporate bond issues, began the year at 5.1 percent and
fell only to 4.5 percent by the time the Fed lowered rates for the ninth
time on Oct. 2. By last week, 10- year yields had actually risen to 4.64
percent.
Yields on the 30-year bond rose even as the Fed cut short-term rates.
Starting the year at 5.45 percent, yields on the long bond hit 5.9 percent
in May.
In an interview yesterday, Peter Fisher, the Treasury's undersecretary for
domestic finance, said that "today's decision is in no way an attempt to
manage long-term interest rates. That is not what motivated us."
But there is no doubt that the sticky nature of longer-term rates has
exasperated policy makers. This is especially the case with mortgage rates,
since consumer spending has been the only prop supporting the economy in
recent months. Keeping consumers feeling flush has, therefore, become a top
priority. One way to do this is by lowering mortgage rates, encouraging
people to refinance their home loans and put more money in their pockets.
The case may have become even more compelling after the report on Tuesday of
a plunge in consumer confidence and other recent reports that home buying
has started to slip. While mortgage refinancing activity has soared since
Sept. 11, the Mortgage Bankers Association's index of home buying activity
has instead stumbled. Existing home sales dropped 5.2 percent in September
from a year earlier and 11.7 percent from August. But the plunge yesterday
in yields on government securities will bring mortgage rates down
significantly and soon.
The Treasury's announcement stunned Wall Street firms. To be sure, the
government had been reducing the amount of long-term bonds in the market by
buying back issues periodically and not issuing new ones. But traders had
come to believe that because the federal budget surpluses have all but
vanished, the government would have to resume heavy borrowings to finance
deficit spending. And the Treasury gave Wall Street none of the usual
warning signs that come in the form of trial balloons floated before a
policy shift as big as this one.
When Treasury prices surged on the news of the bond's demise, most major
brokerage firms were caught with significant losses. Investors rushed to buy
soon-to-be extinct issues. Prices of long-term bonds soared, and their
yields plunged, falling from 5.21 percent on Tuesday to 4.88 percent
yesterday. It was the biggest single-day move since investors fled to the
safety of government securities during the stock market crash of 1987.
Traders who had sold long-term Treasuries short to hedge their holdings in
corporate bonds and mortgage-backed securities got crushed. "This was a
complete blind siding," one trader said. "They would have accomplished the
same thing just by signaling it. But they decide not to signal it, and
everybody on the Street got slammed."