Treasurys drop on Fed statement

Treasury prices caved in Wednesday after the Federal Reserve, while cutting interest rates a quarter point, warned that higher inflation risks could make further reductions unlikely.

The widely expected rate cut left the benchmark federal funds rate at 4.50 percent. But the Fed's accompanying economic assessment statement said higher inflation risks roughly balance out the downside risks to growth from recent credit market problems. The Fed also said "strains in financial markets have eased somewhat on balance."

Analysts said the Fed was putting the markets on notice that Wednesday's rate cut and September's half-point reduction might be all the central bank plans for a while.

"The main reason the bond market does not like the statement is it indicates the Fed is on pause, barring some economic weakness that they don't see and we don't see either," said Alan Tedford, fixed-income portfolio manager at Stephens Capital Management.

The news did not depress other markets in the way it hurt Treasurys. The stock market at first wobbled and then rallied after the news, while the dollar dropped on the rate cut, helping gold futures to top $800 an ounce. Other commodities also gained in after hours trade, including crude futures which neared $94 a barrel.

The benchmark 10-year Treasury note fell 22/32 to 102 6/32 with a yield of 4.47 percent, up from 4.39 percent late Tuesday. Prices and yields move in opposite directions.

The 30-year long bond dropped 1 4/32 to 104 1/32 with a 4.74 percent yield, up from 4.68 percent late Tuesday.

The 2-year note fell 7/32 to 99 14/32 with a 3.92 percent yield, up from 3.81 percent late Tuesday.

The yield on the 3-month note dropped to 3.92 percent from 3.96 percent Tuesday as the discount rate fell to 3.82 percent from 3.87 percent.

Selling pressure in the Treasury market was intensified by rumors this week that the central bank would order a full half percentage point rate decrease, as it did last month. The size of the actual reduction added to investors' disappointment.

"It appears that a significant minority of investors were looking for a half point decrease and/or a clear signal of more eases ahead," said Ian Shepherdson, chief U.S. economist at High Frequency Economics. "They got neither."

The Fed statement said core inflation readings have improved modestly this year, but recent increases in energy and commodity prices could increase inflationary pressure.

If the Fed concludes inflation is the primary risk to the economy, it could in theory switch to a bias toward rate increases. However, Stephens Capital's Tedford said this was unlikely as many expect inflationary pressures to ease at the start of 2008.

The next Fed meeting is Dec. 11.

A report released earlier in the session also held hints that the Fed may not feel the need to cut at the December meeting. The government reported brisk economic expansion during the summer despite the rapid deterioration seen in the credit and housing markets.

The Commerce Department's preliminary third-quarter gross domestic product report showed an annual growth rate of 3.9 percent, exceeding the 3.1 percent expected by economists. The advance was the strongest seen in six quarters and was linked to strong consumer activity and business and military spending. It set helped stoke buying of stocks and selling of low-risk Treasurys.

A regional manufacturing report showed some weakness last month. The Chicago purchasing managers index showed a drop to 49.7 this month from 54.2 in September. Readings below 50 show that more companies are contracting than growing.

Separately, the Commerce Department said construction spending rose 0.3 percent in September, when business construction offset the weakness in home building.

The Treasury Department announced it will auction $13 billion in 10-year notes and $5 billion in 30-year bonds next week to refund maturing securities and pay down debt.