federal reserve to cut rates in 2007

the market here is looking at a very big slowdown.
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Federal Reserve to Cut Rates in 2007, Corporate Bond Sales Show

By Mark Pittman

Sept. 26 (Bloomberg) -- Thinking about refinancing your mortgage in the U.S.? Wait a year. Considering a certificate of deposit? Sign up now.

While economists debate whether the Federal Reserve will cut its target interest rate for overnight loans between banks from 5.25 percent, investors have already decided the central bank will reduce borrowing costs next year.

Nowhere is that clearer than in the market for floating-rate notes, whose interest payments rise and fall with central bank policy. Sales of so-called floaters are slowing for the first time since the Fed started raising interest rates in June 2004. They've fallen to $21.5 billion in September from a monthly average of $35 billion this year through August, according to data compiled by JPMorgan Chase & Co.

``People had bought floating-rate debt to be defensive,'' said William O'Donnell, chief interest-rate strategist at Stamford, Connecticut-based UBS Securities LLC, one of the 22 primary dealers of U.S. government securities that trade with the Fed. ``Now, they're buying fixed interest to be what I'd call offensive and betting on lower interest rates.''

Floating-rate note sales are falling even though they yield an average of 5.61 percent while bonds with fixed interest pay 5.54 percent, according to Lehman Brothers Holdings Inc. in New York. Over the past five years the benchmark for floaters has been higher than 10-year Treasury yields just 15 percent of the time, data compiled by Bloomberg show. Floaters lose value when rates decline because they pay less, while bonds with fixed rates become relatively more attractive.

`We're All Buying'

``We're all buying fixed-rate bonds, something we can get a capital gain out of when yields go down,'' said James Cusser, who manages $1.4 billion in fixed-income securities at Waddell & Reed Inc. in Shawnee Mission, Kansas.

Daniel Fuss, vice chairman at Loomis Sayles & Co. in Boston, who oversees $23 billion and manages the best-performing U.S. corporate bond fund of at least $100 million, says he's ``not interested'' in floating-rate notes because he expects the Fed to cut rates to 4.50 percent in 2007. The $6.65 billion Loomis Sayles Bond Fund has less than 1.5 percent of its assets in floating-rate notes. The fund is up 8.1 percent this year.

CIT Group Inc., the largest lender through the U.S. Small Business Administration, this month sold $500 million each of 5.8 percent fixed-rate bonds due in 2036 and 5.85 percent of notes maturing in 2016. The 30-year securities yielded 105 basis points more than Treasuries, while the 10-year debt yielded 107 basis points more. A basis point is 0.01 percentage point.

CIT Swaps

The company switched from floating-rate sales in part because of investor demand, said Treasurer Barbara Callahan.

``You want to sell what the customer wants,'' Callahan said in an interview. ``We have seen a little bit of a cutback in demand for longer-dated floaters. The view out there is that the Fed has paused and they are close to or at the end of the cycle, and that's why fixed-rate debt is becoming more popular.''

Finance companies loan more money at variable rates than at fixed costs, so they prefer floating-rate notes to avoid the risk of rising interest rates, said Callahan, who has overseen $15 billion in unsecured debt sales this year.

When CIT sells fixed-rate debt, it usually swaps the rate for floating interest payments, according to Callahan. Based on the 10-year sale, the New York-based company paid 7 basis points more than the fixed-rate bond's coupon, or 5.92 percent, to swap the payments to a floating rate, Callahan said. That's an extra $350,000 a year in interest on $500 million.

Residential Capital Corp., the mortgage unit of Detroit- based General Motors Corp., turned to fixed-rate debt for its last bond offering May 11.

ResCap Seeks `Strength'

ResCap, as the company is known, sold $1.15 billion of 5.125 percent securities maturing in 2012 and 6.375 percent notes due in 2013. The securities were denominated in pounds and euros. ResCap in April paid 7.3 percent to sell $1 billion of three-year floating-rate debt in dollars.

``You want to issue into strength, and that strength comes from demand,'' said Louise Herrle, the treasurer of Minneapolis- based ResCap.

Goldman Sachs Group Inc., the most-profitable U.S. investment bank, paid an initial coupon of 5.84 percent when it sold $2.5 billion of 10-year floating-rate notes in March. The firm offered $1.5 billion of 5.75 percent fixed-rate notes due in 2016 on Sept. 14. The difference represents a savings of $1.5 million a year in interest on $2.5 billion.

Goldman expects the Fed to reduce interest rates to 4 percent by the end of next year, according to Edward McKelvey, the firm's senior U.S. economist.

Slowdown in Sales

Demand for floating-rate notes increased when the Fed began raising rates from a 45-year low of 1 percent two years ago. Sales jumped 50 percent to $286 billion in 2004 from $190 billion the year before, according to JPMorgan, the biggest underwriter of U.S. bonds. They climbed to $299 billion in 2005 and reached a record $301 billion so far this year.

Sales slowed after the Fed left interest rates unchanged on Aug. 8. Fed funds futures traded on the Chicago Mercantile Exchange reflect about a 40 percent chance the central bank will lower its target rate to 5 percent by the end of January.

Economists are less certain about the direction of interest rates than money managers, who are snapping up U.S. government debt. The yield on the U.S. 10-year note tumbled to 4.54 percent yesterday from 5.25 percent in June. By contrast, 34 of the 72 economists in a Bloomberg survey published Sept. 8 predict rates will end 2007 at 5 percent or higher.

Economy Outlook

Merrill Lynch & Co. and Goldman, the two big Wall Street firms that predicted the rally, are telling clients to buy two- year Treasuries to prepare for Fed rate cuts next year. Some of the other big investment banks disagree. Bear Stearns & Co. says rates will reach 5.75 percent by the end of 2007, while Lehman predicts 5.50 percent and Morgan Stanley anticipates 5.25 percent. All the firms are in New York.

U.S. growth will slow to 2.7 percent, according to the median estimate in the Bloomberg survey, compared with the average of 3 percent over the past two years.

``The markets are telling us that the Federal Reserve is going to cut rates in the middle of next year,'' David Wyss, S&P's chief economist, said in an interview from his office in New York. The Fed will have to lower rates because ``the economy is going to cool off faster than they thought.''

Pacific Investment Management Co., which oversees about $600 billion, including the world's biggest bond fund, anticipates reduced rates. The Newport Beach, California-based firm's chief investment officer, Bill Gross, has been forecasting lower central bank rate targets since at least February.

``You're better off buying fixed,'' said Pimco Executive Vice President Mark Kiesel, who manages the firm's $6 billion corporate bond fund.

Pimco Prediction

Pimco predicts the fed funds rate will be 4 percent by December 2007 because the drop in home sales is greater than central bank policy makers anticipated, Kiesel said.

Richard Knee, who oversees $50 billion for Lehman Asset Management in Chicago, said floating-rate notes are not as attractive as fixed because the market expects the Fed to cut its target to 4.25 percent.

Floating-rate debt won't disappear because some investors buy the notes as a substitute for money market securities, Knee said. The average floating-rate note yields 5.61 percent, compared with 4.73 percent for all taxable money funds, according to Lehman and the Westborough, Massachusetts-based Money Fund Report.

Rate Differential

The three-month London interbank offered rate, a level set daily by banks that's the base for most floating-rate notes, is 0.82 percentage point higher than the yield on the 10-year U.S. note, the benchmark for most fixed-rate debt. The gap is the widest since January 2001.

``We buy a lot of floaters as cash equivalents,'' Knee said.

While companies selling fixed-rate bonds have added expenses for exchanging interest payments into floating obligations, their financing costs may still be lower.

Corporate bond yields have dropped to an average of about 6.23 percent from this year's high of 6.90 percent on June 28 as government securities rallied and the lending premium investors demand compared with Treasuries narrowed, according to Merrill Lynch index data.

Lower Mortgage Payments

Investment-grade corporate bonds in the U.S. yield 97 basis points more than Treasuries, down from 98 in June, according to a Merrill Lynch index that tracks more than 3,200 securities worth $1.9 trillion.

The outlook for lower interest rates also shows why mortgage refinancings have held at about the lowest since 2002, according to the Mortgage Bankers Association of America, a Washington- based trade group.

The average monthly payment on a $200,000 mortgage with a rate that adjusts every year is now $1,141, according to Freddie Mac, the second-biggest provider of money to the U.S. housing industry. Home buyers pay an average 6.4 percent for a 30-year fixed-rate loan, with a monthly bill of $1,251.

If Goldman's McKelvey is right, homeowners with adjustable rates mortgages would cut their monthly payments by about $260. The last time Fed rates were at 4 percent, 30-year fixed mortgages averaged 6.32 percent and cost $12 less a month than they do now.

``An adjustable-rate mortgage can be pretty darn quickly affected,'' S&P's Wyss said. ``The monthly payment has been ticking up and wouldn't it be nice if it ticked back down?''

To contact the reporter on this story: Mark Pittman in New York at [email protected]