Greenspan's Words Send Yields to New Lows for the Year

Bond market participants didn't think he had it in him.
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Treasuries staged a huge rally that dropped yields to new lows for the year in response to an indication from Fed Chairman Alan Greenspan that the central bank is likely to lower interest rates in the months ahead.

The government bond market also benefited from weak economic data, but the Greenspan speech was far and away the more important influence.

The bond rally occurred in spite of the equally huge rally in the stock market. Rallies in the stock market, though rare this year, have put pressure on bond prices because they reduce the appeal of bonds as an alternative investment. Also, to the extent that rising stock prices indicate optimism about the economy, they call for higher interest rates and lower bond prices.

But as Michael Pianin, a trader at

Fuji Securities

, noted, rallies in the stock market -- because they have been rare -- have proven much less detrimental to the bond market than stock-market selloffs have benefited bonds. "It's definitely not a two-way street," he said.

The benchmark 10-year

Treasury note rose 30/32 to 102 12/32, lowering its yield 11.5 basis points to 5.430%, the lowest since May 5, 1999.

Shorter-maturity issues fared even better, as they typically do when people become more optimistic about interest-rate cuts. The two-year note rose 6/32, dropping its yield 14.3 basis points to 5.490%, the lowest since July 21, 1999. And the five-year note rose 17/32, lowering its yield to 12.6 basis points to 5.349%, the lowest since May 6, 1999.

The 30-year

Treasury bond rose 1 19/32 to 109 15/32, dropping its yield 9.6 basis points to 5.590%.

At the

Chicago Board of Trade

, the March

Treasury futures contract added 27/32 to 102 24/32.

In a

speech to an

America's Community Bankers

conference, Greenspan acknowledged that the economy is at risk of slowing too much, implying that the Fed will lower interest rates to keep that from happening.

High energy prices are the chief culprit, Greenspan said. They have put pressure on corporate earnings, which has caused stock prices to fall and interest rates for corporate borrowers to rise. The fall in stock prices is slowing consumer spending by eroding consumer confidence. And the rise in interest rates for corporate borrowers is slowing spending by businesses. Spending by consumers and businesses accounts for about 80% of U.S. economic activity.

Greenspan did not suggest that rate cuts are imminent. Financial market conditions are much less strained now than they were in the fall of 1998, when the Fed cut rates three times in quick succession, he said.

But his remarks convinced investors beyond the shadow of a doubt that the Fed will lower interest rates by the end of the first quarter, probably by the end of February. The odds of a rate cut by the end of the first quarter implied by

fed funds futures contracts rose to 170% from 128% yesterday. The odds of a rate cut by the end of February rose to 116% from 90%.

As a first step toward easing, the

Federal Open Market Committee will likely shift its assessment of the risks facing the economy at its next meeting on Dec. 19, bond market participants said.

In the

statement it releases after its meetings, the FOMC opts for one of three assessments of the economy. Either the risk of rising inflation is greater than the risk of slowing growth, or the risk of slowing growth is greater than the risk of rising inflation, or the two risks are in balance. Since early 1999, the committee has declared inflation the greater risk. Two weeks from today, market participants predict, it will shift to a risks-balanced assessment, at the very least.

"The comments by Greenspan show a different stance than the tight money stance they've had till now," said Chris Fitzmaurice, co-head of government bond trading at

Salomon Smith Barney

.

Fitzmaurice thinks the FOMC may go so far as to lower the

fed funds rate at its next meeting. Economic conditions call for it, he says. "The economy is slowing harder and faster than anticipated."

Prior to the speech, most bond market participants were of the opinion that the Fed would shift to a balanced assessment of the economy in December, and lower rates during the first quarter. But they did not expect Greenspan to come out and say so. That's why the market reacted so strongly, said David Connors, head of government bond trading at

Credit Suisse First Boston

.

"Before the speech, nobody I spoke to expected anything to come of it," Connors said. Perhaps that was because according to the Fed, the topic of the speech was supposed to be "Banking and the economy." The speech Greenspan ultimately gave was titled "Structural changes in the economy and financial markets."

Plus, the comments were "unusually direct," Connors said. "It was clearly targeted towards financial markets and the message was delivered very effectively."

The bond market also benefited from the news that

factory orders

(

definition |

chart |

source

) fell more sharply than expected in October. Orders for manufactured goods, an indicator of the health of the factory sector, fell 3.3%. Economists polled by

Reuters

had forecast a 2.7% drop. Also, the report revised the declines in

durable goods orders

(

definition |

chart |

source

) that were reported last week to 5.6% overall (from 5.5%) and 2.3% excluding transportation (from 2.2%).

The weekly retail sales reports, which are normally not market movers, were also extraordinarily weak. The

BTM Weekly U.S. Retail Chain Store Sales Index

(

definition |

chart ) fell 2.6% in the latest week, its biggest drop in over four years. And the

Redbook Retail Average

(

definition |

chart ) found December sales running 0.1% ahead of November after one week, widely missing the target of 1.0%.

In other bond market news,

British Telecom

(BT)

sold $10 billion of bonds today in the largest-ever dollar-denominated

corporate bond sale.

Economic Indicators

In other economic news, the

Purchasing Managers Non-Manufacturing Index

(

definition |

source

) rose to 58.5 in November from 58 in October.

Currency and Commodities

The dollar rose against the yen and the euro. It lately was worth 111.10 yen, up from 110.96. The euro was worth $0.8796, down from $0.8890. For more on currencies, see

TSC's

Currencies column.

Crude oil for January delivery at the

New York Mercantile Exchange

fell to $29.53 a barrel from $31.22.

The

Bridge Commodity Research Bureau Index

fell to 229.73 from 231.84.

Gold for February delivery at the

Comex

fell to $273.30 an ounce from $273.80.