US government bonds rallied again on Friday as investors interpreted the Federal Reserve's emergency decision to lower its discount rate as a step toward a broader easing of monetary policy.
The Fed's ad hoc policy meeting on Thursday night, its discount rate cut on Friday morning for loans the Fed makes directly to banks, and its statement that the risks to economic growth had risen, only reinforced the market's perception that the global credit squeeze is a serious matter.
US Treasuries rallied further in response, with two-year notes rising 4/32 for a yield of 4.16 percent, a drop of 9 basis points for the day, after falling a full percentage point in just two months. "This is a prelude to the Fed easing at some point down the line," said Mary Ann Hurley, senior Treasury market trader at D.A. Davidson.
Futures markets envisioned a strong probability of a cut in the federal funds rate target for overnight interbank lending, the Fed's main monetary policy tool. The gains in Treasuries on Friday occurred despite a rise the price of riskier assets like stocks, and a narrowing of credit spreads.
This disconnect suggested bond dealers were unconvinced the crisis was near an end. "It seems unlikely that the recent bout of volatility is over," said Thomas Higgins, chief economist at Payden & Rygel. Apart from bringing down the discount rate, the Fed's accompanying statement effectively shifted its anti-inflation stance to a more balanced assessment of risks.
This amounted to recognition that the credit crunch could present challenges for an economy that has already shown signs of slowing. The latest sign of economic stress came from a report showing US consumer sentiment for August deteriorating to its weakest in a year.
The Reuters/University of Michigan Surveys of Consumers said its preliminary reading on consumer sentiment in August was 83.3, well below a median forecast of 88.0 and a sharp fall from the previous month's final reading of 90.4.
The combination of evaporating liquidity, a credit squeeze, and a reticent consumer could prove damaging to economic growth, potentially tipping the economy into recession, analysts said. With that in mind, dealers bid benchmark 10-year Treasury notes 8/32 higher, bringing their yield three basis points lower to 4.67 percent.
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