Fed goes for shock effect, and markets respond as hoped

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The Federal Reserve went for a major shock-and-awe effect with its interest rate cut and other moves today aimed at rescuing the economy from a devastating downturn.

The central bank’s announcements are moving markets in the way the Fed wants: Long-term interest rates are tumbling and the stock market has surged.

‘It is strong medicine that has shocked the markets and maybe, just maybe, it will shock the economy into life again,’ said Christopher Rupkey, an economist at Bank of Tokyo Mitsubishi in New York.

Instead of cutting its key short-term rate to 0.5%, from 1%, as most analysts expected, the Fed set a new target range of 0% to 0.25% for the rate.

And policymakers, in their statement, said that ‘weak economic conditions are likely to warrant exceptionally low levels [of short-term rates] for some time.’

That’s a way to prod investors to take more risk -- say, by buying long-term bonds, or stocks -- because the Fed is saying there may not be any return at all on safe, short-term securities for quite a while.

Maybe investors should have figured as much, but they’re still responding today as Fed Chairman Ben S. Bernanke and his peers had hoped: The yield on the 10-year Treasury note has fallen to a generational low of 2.30%, from 2.53% on Monday, as buyers have rushed in. The 30-year T-bond yield has dropped to 2.81% from 3%.

‘The theme of ‘low for longer’ will push interest rates lower across the yield curve,’ said Tony Crescenzi, bond market strategist at Miller, Tabak & Co. in New York.

On Wall Street, the Dow Jones industrial average was up 335 points, or 3.9%, to 8,899 with about 20 minutes to go in the trading session.

The Fed also signaled that it would continue to directly buy mortgage-backed bonds and other debt securities for its own portfolio as a way to put more downward pressure on long-term interest rates, such as for home loans. And it gave an extra jolt to the Treasury bond market by confirming that it was ‘evaluating the potential benefits of purchasing longer-term Treasury securities.’

The yield on mortgage finance giant Fannie Mae’s benchmark 30-year mortgage-backed bond has fallen to a 52-week low of 3.88% today, from 4.16% on Monday.

The sacrificial lamb in the Fed’s moves: the dollar, as falling interest rates will make U.S. fixed-income investments less attractive for some foreign investors.

The euro has jumped to $1.405 from $1.367 on Monday.

-- Tom Petruno