Yields Rise Slightly Ahead of Expected Rate Cut

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Treasury bond prices are a bit lower this morning as traders await the outcome of today's

Federal Open Market Committee

meeting, at which the

Fed

is widely expected to drop the fed funds rate, the key short-term interest rate, by either 25 or 50 basis points from 5.5%.

Expectations as reported by

Reuters

"We've had a good run; now people are lightening their books a little bit, doing some minor tweaking" ahead of the announcement, expected around 2:15 p.m. EDT, of any rate change, said Scott Graham, co-head of government bond trading at

Prudential Securities

.

At 11:16 a.m. EDT, the benchmark 30-year Treasury bond was down 2/32 at 105 14/32, its yield unchanged at 5.14%. Short-maturity Treasuries, whose yields are more closely tied to the short-term rates set by the Fed, were weaker. The two-year note, the shortest of the coupon securities, was off 1/32, its yield rising 1 basis point to 4.45%.

If you needed proof that the bond market, singularly focused on the Fed, couldn't care less about domestic economic data, you got a bit of that this morning. The Conference Board's

consumer confidence index

, the most widely followed indicator of consumer attitudes, tumbled to 126 in September from 133.1 in August. It's now at its lowest level since October.

Under normal circumstances, this news would hearten bond traders with its suggestion that consumer spending is likely to slow, keeping the U.S. safe for low interest rates. As it is, widespread fear of financial risk has them fully persuaded that Treasury yields aren't going anywhere but down for a while.

What will happen this afternoon after the FOMC's decision is announced? "Everybody's saying that if they do 25 it goes down and you're supposed to buy it," Graham said. Translation: With the long bond's yield more than 35 basis points below the fed funds rate and all shorter Treasury yields roughly 100 basis points below it, the market is pricing in more than a 25-basis-point cut. It wants 50, and if it doesn't get 50, it's going to pitch a fit, and prices are going to fall. But traders want to buy at those lower prices because they remain convinced that rates are headed lower.

"If they do 50," Graham said, the expectation is "we're going to get a spike and you're supposed to sell it." Meaning that while the market wants a 50-basis-point cut, it hasn't fully priced one in. So prices will rise on a 50-basis-point cut, and traders will take the opportunity to sell at the highs.

The problem, Graham said, is that "if everybody's looking for the same thing, it's not likely to play out that way."

More certain, he says, is that in the event of a 50-basis-point cut, the yield curve will steepen, possibly drastically. As measured by the difference in yield between the two-year note and the 30-year bond, the curve is currently 69 basis points. It has already undergone a significant amount of steepening since mid-summer. It dropped to a multi-year low of 13 basis points in July, and has been steepening pretty steadily since mid-August, when it was 22 basis points. But 69 is still low by historical standards: Going back to January 1991, the spread has been as high as about 350 basis points.