Chicago, March 7 (Bloomberg) -- The Federal Reserve will cut its target lending rate one more time, to 1 percent, and leave it there until the middle of 2004, interest-rate futures suggest. Fed policy makers meet on March 18, May 7 and June 26. Traders are betting they will trim the average overnight rate for loans between banks, or the federal funds, by a quarter percentage point by May. The yield on the Chicago Board of Trade's May fed- funds futures contract fell to 1.11 percent, its all-time low. The contract ``is a very good gauge of what the Fed will do, and it's suggesting a cut,'' said John Brady, a broker for Man Financial. Once the central bank lowers its target, ``we'll stay there for a while.''
Tumbling stocks, declining consumer confidence and the prospect of a U.S.-led war in Iraq may prompt the Fed to lower rates for a 13th time since January 2001, some traders said. Federal Reserve Governor Edward Gramlich said yesterday that the bank can still pare rates to combat slowing growth. The 1.25 percent target is the lowest in four decades. The central bank may cut its target more than futures suggest, possibly to as low as 0.5 percent by September, said Lou Brien at DRW Trading, the world's biggest Eurodollar-options trader. ``When you haven't got many bullets left you've got to use them for the maximum effect,'' he said. The Standard & Poor's 500 Index has dropped 6.6 percent this year, consumer confidence fell to a nine-year low last month and oil prices have surged 6 percent in the past month. The central bank's survey of regional economies said consumer spending was ``weak'' and business spending ``soft.'' The unemployment rate rose to 5.8 percent last month and the economy lost 308,000 jobs, according to government reports. Analysts had expected the economy to add 10,000 jobs.
Eurodollars
The yields on June and September Eurodollar futures, gauges of three-month lending rates, have also fallen below the central bank's target, showing traders expect the Fed to keep a 1 percent rate for the rest of the year. The yield on the June contract fell to a record 1.14 percent. The September contract, which dropped to 1.15 percent, had yielded as much as 1.49 percent last month. Three-month lending rates are typically 18 to 25 basis points above the Fed's target when policy makers are seen keeping rates steady. A narrower gap is a sign traders are betting on a reduction. A basis point is 0.01 percentage point.
`Not Going to Rebound'
Speculation the U.S. will attack Iraq by the end of the month and bear the majority of the cost of a war is also driving investor demand for interest-rate futures, traders said. Like bonds, when prices on interest-rate futures rise, yields fall. ``Traders are behaving as if the economy is not going to rebound and the war is going to last longer'' than a few weeks, said Alexis Zacharopoulos, head Eurodollar salesman for the Gelber Group. ``No one is going to sell in front of the possible war,'' because they don't want to risk losing money if prices rise. The difference between one- and two-year interest rates based on Eurodollar futures, a yardstick for traders' expectations for Fed policy changes in 12 to 24 months, is the narrowest in almost two years.
The gap, which shrinks when traders reduce expectations for interest-rate increases, touched 41 basis points on March 5, the narrowest since April 19, 2001. The Fed lowered its benchmark rate 11 times in 2001 by a total of 4.75 percentage points, to 1.75 percent. It lowered the rate to 1.25 percent in November. The European Central Bank yesterday lowered its key rate a quarter percentage point to 2.5 percent, and futures show it will cut another quarter point by June.
`Not a Statement'
Some traders said the decline in the yield on Eurodollar futures indicates investors are guarding against declines in other assets they trade, not just making a bet on borrowing costs. ``Sometimes when people buy Eurodollars it's because they need to hedge risk,'' said Peter Yastrow, senior vice president and a broker at Man Financial. ``It's not a statement and shouldn't be taken as a Fed policy prediction or insight.'' For example, a bond trader betting interest rates will drop before he gets a chance to buy three-year Treasury notes when the government brings them back in May can buy Eurodollar futures to lock in today's yield for the next two months. Futures traders have been wrong before. In April of last year, Eurodollar contracts suggested the Fed would raise its key rate to 4 percent in the next 20 months to combat accelerating inflation.
`Pretty Crummy Numbers'
The decline in yields on Eurodollar and fed-funds futures also reflects traders' and investors' concerns that the Fed will need to cut rates to induce consumers and companies to help revive the economy by spending more. ``For a while a lot of people were thinking the (prospect of) war was holding the economy back, and were it not for the war maybe the economy wouldn't be so bad,'' said Glenn Compton, a broker for Salomon Smith Barney. ``War isn't helping, but many companies are still looking for pretty crummy numbers earnings- wise for the rest of the year.'' //www.quote.bloomberg.com