November 1, 2001 Wall Street Stunned by Treasury's Action on Long-Term Bonds By GRETCHEN MORGENSON With fears mounting that nine interest rate cuts in almost as many months may not be enough to rev up the United States economy, the Treasury Department added some high-test yesterday to the Federal Reserve's fuel mix. Unfortunately, Wall Street got run over in the process. Treasury officials said that their decision to halt the issuance of 30-year bonds was intended to save the government money. But traders scoffed at that explanation, viewing the move as an almost desperate effort to push down long-term interest rates, which had remained stubbornly high, and prod both corporate and individual borrowers to spend again. "Without a doubt the thing that the Fed really wants to do is get mortgage rates and corporate rates down," said Peter McTeague, government bond market strategist at Greenwich Capital Markets, a brokerage firm in Greenwich, Conn. "But mortgage rates weren't falling as much as people hoped because they are more driven by the long end of the yield curve. So they're trying every little trick in the basket. If the Fed funds rate isn't going to do it, let's see if we can do something else." The predicament for the Fed has been that even as it slashed interest rates from 6.5 percent at the beginning of the year to 2.5 percent last month, longer-term borrowing costs for corporations and individuals had not fallen as hard. For example, yields on the 10-year note, the benchmark for many mortgage rates and corporate bond issues, began the year at 5.1 percent and fell only to 4.5 percent by the time the Fed lowered rates for the ninth time on Oct. 2. By last week, 10- year yields had actually risen to 4.64 percent. Yields on the 30-year bond rose even as the Fed cut short-term rates. Starting the year at 5.45 percent, yields on the long bond hit 5.9 percent in May. In an interview yesterday, Peter Fisher, the Treasury's undersecretary for domestic finance, said that "today's decision is in no way an attempt to manage long-term interest rates. That is not what motivated us." But there is no doubt that the sticky nature of longer-term rates has exasperated policy makers. This is especially the case with mortgage rates, since consumer spending has been the only prop supporting the economy in recent months. Keeping consumers feeling flush has, therefore, become a top priority. One way to do this is by lowering mortgage rates, encouraging people to refinance their home loans and put more money in their pockets. The case may have become even more compelling after the report on Tuesday of a plunge in consumer confidence and other recent reports that home buying has started to slip. While mortgage refinancing activity has soared since Sept. 11, the Mortgage Bankers Association's index of home buying activity has instead stumbled. Existing home sales dropped 5.2 percent in September from a year earlier and 11.7 percent from August. But the plunge yesterday in yields on government securities will bring mortgage rates down significantly and soon. The Treasury's announcement stunned Wall Street firms. To be sure, the government had been reducing the amount of long-term bonds in the market by buying back issues periodically and not issuing new ones. But traders had come to believe that because the federal budget surpluses have all but vanished, the government would have to resume heavy borrowings to finance deficit spending. And the Treasury gave Wall Street none of the usual warning signs that come in the form of trial balloons floated before a policy shift as big as this one. When Treasury prices surged on the news of the bond's demise, most major brokerage firms were caught with significant losses. Investors rushed to buy soon-to-be extinct issues. Prices of long-term bonds soared, and their yields plunged, falling from 5.21 percent on Tuesday to 4.88 percent yesterday. It was the biggest single-day move since investors fled to the safety of government securities during the stock market crash of 1987. Traders who had sold long-term Treasuries short to hedge their holdings in corporate bonds and mortgage-backed securities got crushed. "This was a complete blind siding," one trader said. "They would have accomplished the same thing just by signaling it. But they decide not to signal it, and everybody on the Street got slammed."