U.S. 2-Year Notes Fall As Fed Raises Rates; Yield Curve Narrows

(Bloomberg) -- U.S. Treasuries maturing in five years or less fell after the Federal Reserve increased its interest-rate target and reiterated that rates probably will continue to rise at a ``measured'' pace to keep inflation tame.
Yields on interest-rate futures contracts surged in a sign that traders have greater conviction about more rate increases. The Fed said the economy faces only ``near term'' setbacks in employment, spending and production after Hurricane Katrina, disappointing some traders who anticipated policy makers to signal they were close to done lifting borrowing costs.
``There's no reason to expect they're going to stop tightening at the next meeting,'' said Eric Hiller, head of interest-rate strategy at Bank of America Corp. in Chicago. ``We're pricing in some risk of getting north of 4 percent by year-end'' from 3.75 percent, he said. The company is the second- largest U.S. bank.
The benchmark two-year note's yield rose 8 basis points, or 0.08 percentage point, to 4 percent at 4 p.m. in New York, according to bond broker Cantor Fitzgerald LP, the highest since Aug. 30. Yields move inversely to bond prices. The 4 percent note due in August 2007 fell about 1/8, or $1.25 per $1,000 face amount, to 100.
Ten-year Treasuries were little changed on speculation the Fed's increases in its target for the overnight lending rate between banks will keep inflation in check by curbing economic activity. The benchmark 10-year note's yield rose less than 1 basis point to 4.25 percent. The price of the 4 1/4 percent security due in August 2015 was little changed at 100. The 5 3/8 percent bond due in February 2031 rose about 3/8 to 112 3/4
Inflation erodes the value of bond's fixed interest payments, with the biggest impact on the longest-maturity securities. Shorter-maturity yields are more sensitive to expectations for monetary policy.
Yield Outlook
``The key to the 10-year rate is expectations for inflation pressures in the long term, which are not going to be increasing,'' said Colin Robertson, managing director of fixed income at Chicago-based Northern Trust Bank, which manages $250 billion of fixed-income assets. ``If that's the case, 10-year yields between 4 and 4.5 percent are to be expected.''
The 10-year note's yield was 4.69 percent on June 29, 2004, the day before the Fed began increasing rates. The note rallied after the last rate increase on Aug. 9, with the yield falling 3 basis points to 4.39 percent.
Fed policy makers lifted their target for the overnight lending rate between banks from 3.50 percent, the 11th straight increase. The Fed next meets to decide interest rates Nov. 1.
The yield on the December federal funds futures contract at the Chicago Board of Trade rose 6.5 basis points to 4.02 percent, indicating traders are certain the Fed will lift the rate to 4 percent by year-end and see a 13 percent chance of a 4.25 percent rate. Yesterday they saw no chance of a 4.25 percent year-end rate.
Expectations
Economists at 18 of the 22 primary dealers of U.S. government securities that trade with the Fed's New York branch predicted an increase in the target rate, according to a Bloomberg survey.
Economists at 16 dealers said the central bank, whose statements announcing its rate increases since May 2004 have said policy makers believe rates can rise ``at a pace that is likely to be measured,'' would repeat the phrase today. Three firms said it would be dropped and three didn't give a prediction.
Hurricane Katrina raised doubt among some investors and economists that the Fed would raise borrowing costs. The costliest natural disaster in U.S. history sent fuel prices to record highs and will shave half a percentage point or more off U.S. economic growth in the second half of the year and cost 400,000 jobs the Congressional Budget Office told lawmakers.
Fed Statement
``While these unfortunate developments have increased uncertainty about near-term economic performance, it is the Committee's view that they do not pose a more persistent threat,'' the Fed's statement said. ``Higher energy and other costs have the potential to add to inflation pressures,'' the statement also said.
High fuel costs eroded consumer sentiment, surveys this month showed, raising concern fuel prices will dent spending and corporate profits.
The University of Michigan on Sept. 16 said its preliminary September index of consumer confidence had the biggest drop since December 1980, falling to a 13-year low.
Yield Curve
The gap between two- and 10-year yields, known as the yield curve, shrank by the most since May 6 as investors pared expectations for inflation.
The difference narrowed 7 basis points to 26 basis points. The gap was 191 basis point in June 2004, when the Fed started raising rates.
On Aug. 29 the curve narrowed to 12 basis points, the smallest since the Fed began a series of interest-rate cuts in January 2001, and then widened to 33 basis points yesterday amid concern surging fuel prices would slow economic growth and the Fed's pace of rate increases.
``When there was confusion on whether the Fed would stay on the measured pace the curve steepened,'' said Richard Volpe, head of government bond trading at Bear Stearns & Co. in New York. ``Now we've got verification that Fed is still in the tightening mode we're seeing people exit out of those of front end securities.''
Inflation
``The economy is resilient and it will bounce back,'' Amitabh Arora, head of U.S. interest-rate strategy at Lehman Brothers Inc. in New York, said before the decision. ``Inflation fear is there and it is getting stronger.''
Speculation the Fed would pause was damped last week after the Fed's New York and Philadelphia branches said last week that factories paid more for materials this month even as business slowed, indicating inflation may be poised to quicken.
The federal funds target is headed ``much higher than 3.75 percent,'' Joseph LaVorgna, chief U.S. fixed income economist at Deutsche Bank Securities in New York, said before the decision. ``The market is totally mispriced for that situation.''
A weekly investor sentiment survey released today by JPMorgan Chase & Co. shows 39 percent of participants expect Treasuries to fall in price, down from 58 percent last week.
Seven percent bet that Treasuries will gain, compared with 8 percent last week. The percentage of investors who expect Treasury prices to remain unchanged rose to 54 percent, the most since July 2004, from 34 percent.

To contact the reporter on this story:
Elizabeth Stanton in New York at estanton@bloomberg.net