As Bond Yields Fall Through Fed Funds, Now What?

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Well, Treasuries have done it. The 5.5% fed funds rate has been vanquished -- for now.

But after covering shorts (and having a tall one), traders will find that the strategy of loading into Treasuries becomes muddled. There's no

Federal Open Market Committee

meeting until the end of baseball season. Then again, Treasuries are still yielding more than sovereign debt in Germany, Japan and various Eastern European countries.

"We are long-term bullish; we're not going down on a straight line, and maybe we got a little ahead of ourselves," said Bill Hornbarger, fixed-income strategist at

A.G. Edwards

. "Maybe our market is rich to fed funds, but it is still cheap to the rest of the world."

That attitude reinvigorated the market today, which at one point today showed the long bond yield at 5.38%. That leaves this market in a paradoxical situation: Investors and economists, who spoke so confidently of Treasuries a few months ago, are now left to decide whether this market should continue to trade through Treasuries despite economic data, or to find another option for investing.

Sources said corporate bonds might begin to look attractive, as might agency and municipal debt. Some said the message is clear: Keep buying Treasuries. The U.S. is in a deflationary environment, equity prices have been riding an uncertain path for several months, and most other assets, including commodities and foreign stocks, have also performed erratically.

"The only way to survive a deflation is in high-grade bonds," said Michael Shamosh, chief bond market strategist at

Tucker Anthony

. "There are a lot of tools for surviving inflation: gold, real estate, art. But for deflation there's little."

Shamosh said the best combination for investing right now is in the safety of Treasuries and some speculation in emerging-markets debt, because all countries have been tarred with the same brush.

"People are basically throwing that entire market out the window," he said. Several countries, such as Thailand, are moving actively to fix their problems but are squashed by the herd fleeing from Russia, Japan, most Asian countries and parts of Latin America as well.

"We're overweight in Treasuries than where we are typically because we're concerned about the liquidity factor in the market," said Barbara Kenworthy, head of fixed income at

Prudential Investments

. "Given the tremendous selloff, emerging markets are beginning to look more valuable, but we've had so many periods where bottom fishing wasn't rewarded."

Kenworthy said the trading today smacked of capitulation -- mortgage investors realizing prepayments will hurt their duration and performance, and therefore buying into Treasuries; emerging-markets investors doing the same, as well as the usual bouncing around by asset allocators moving away from stocks. With more buyers recovering losses by putting money into Treasuries, more mortgage-backed-securities investors can be forced back into Treasuries due to heavy prepayments.

And as yields tick lower, the inevitable discussion of the fed funds rate ensues. In the last several weeks, the market has pushed against the short-term rate in a tentative, choppy manner before finally bulling through it this morning on more Russian woes.

But with that rate surpassed, investors now have to contend with the dichotomy of trading through fed funds with no ease in sight and weak global fundamentals. Too many economic data point to the Fed remaining neutral, but if the bond can no longer rally, the strategy is finding where the money goes otherwise. With U.S. government investors holding long positions, the frenzied buying has come from global players.

This becomes dangerous, as global institutions and individuals, which have been buying more Treasuries than foreign central banks, will shift money into their economies at the first signs of stability. The Japanese and Chinese central banks have reportedly been selling Treasuries to shore up their currency problems.

"This is interesting because if the yield worsens, we'll see

the bond go down pretty hard," Kenworthy said. "People will take their hedge positions and punt them, and probably take a shorter duration."

Sectors that have been otherwise beaten up may attract those who do not believe Treasuries will sustain these levels. "You can't feel comfortable holding in at these levels," said David Shabelman, Treasury market analyst at

Standard & Poor's MMS

. These include agency and municipal debt and high-grade corporate bonds, all of which were shellacked on the Treasury rally.

With the entire curve below funds, the other strategy is to bet on a rate cut. Hornbarger believes it will happen, and is projecting a 5% yield within six to 18 months. The February 1999 futures contract is yielding 5.33%, indicating the market expects an ease by that time.

The next FOMC meeting is at the end of September, and fed officials have made it clear that the strength in housing, labor and consumer dollars -- without inflation pressures -- takes precedence over global pressures. By their view, this economy does not need more stimulus.

"I fully expect over the next couple weeks we'll get an idea of what they talked about

at Tuesday's meeting," Hornbarger said.