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April 24, 2007

DJ RATE FUTURES REPORT: Market Sees 3Q Rate Cut On Weak Housing

By Howard Packowitz

CHICAGO (Dow Jones)--Signs of a deteriorating housing market provided the catalyst Tuesday for higher futures prices on short- and long-term interest rates, virtually locking in expectations for the Federal Reserve to cut the benchmark rate in the third quarter.

Even so, there were reports of active options trading in the Eurodollar futures interest rate market, indicating that some investors were hedging their bets on whether a rate cut would actually occur. Future economic data reports, for example, could shift market sentiment the other way.

Early Tuesday, the National Association of Realtors reported that sales of existing homes plunged 8.4% in March, the sharpest monthly decline in almost two decades.

Also, U.S. home prices in February fell 1.5%, compared with the same time a year ago, in 10 major cities that are part of the Standard & Poor's/Case-Shiller home price index. February was the second straight month to register year-over declines, and it represented the fastest slide in home prices since late 1993.

Traders closely monitor housing data in assessing whether financial troubles afflicting subprime lenders are spilling over to the rest of the housing market. Subprime lending refers to loans given to homebuyers with poor credit ratings.

A report on new-home sales for March is scheduled to be released Wednesday at 10 a.m. EDT (1400 GMT).

At the close of Tuesday's regular trading session, the September Eurodollar futures contract priced in about a 96% chance that the Fed would reduce the key short-term rate to 5%, from the current 5.25% level. That compares with about an 84% chance for a 5% third-quarter rate as factored in at Monday's close.

Eurodollars futures are quarterly contracts linked to U.S. dollars on deposit at foreign commercial banks. The contracts reflect three-month settlement expectations for the London Interbank Offered Rate, or Libor, but they're actively traded by investors seeking exposure to U.S. interest rates.

Bucking the upward price trend, market participants reported active buying of put options tied to the September Eurodollar contract, in case prices turn the other way and traders see the possibility of a rate increase.

During about a one-hour period after the existing-home sales report was released, three brokerage firms combined to perform almost 38,000 put spreads, simultaneously buying and selling September futures contracts to hedge against a third quarter rate increase, participants said.

"They're the cheapest things on the board to protect against any chance of a hike," said Jeff Horwich, a broker and senior vice president of interest rate sales for TJM Investment Services.

The options plays may also have been an attempt by traders who were on the wrong side of the market to "stop the bleeding," said John Welsh, a futures broker and senior vice president of the Peregrine Financial Group.

During Tuesday's session, put options were considered a bargain because prices were trending higher. Options are thought of as protection because they grant traders the right, but not the obligation, to buy or sell a futures contract.

Higher rate futures prices early Tuesday, prior to the existing-home sales data release, and price gains made Monday indicated that many participants anticipated a weak report.

Traders in Treasury futures at the Chicago Board of Trade bought futures Monday and early Tuesday, hedging their short positions in advance of the data, according to Bernard Hanley, a Treasury futures floor broker for Fortis Futures. A trader holding a short futures position anticipates lower prices and higher implied rates.

The June 10-year Treasury notes and 30-year Treasury bonds contracts each climbed to three-week highs early Tuesday, with 10-year notes rising to a level that sent the contract below the 4 5/8% cash yield equivalent. In interest rate markets, higher prices equate to lower implied yields.

Jun Eurodollars 94.68 Unchanged
Sep Eurodollars 94.84 Up 3 basis points *
Dec Eurodollars 95.05 Up 4 basis points
May Fed Funds 94.76 Unchanged
Jun 10-Year Notes 108-10+ Up 6+/32
Jun 30-Year Bonds 111-23 Up 8/32

*A basis point is equivalent to 1/100th of a percentage point.

-By Howard Packowitz, Dow Jones Newswires; 312-750-4132; (END) Dow Jones Newswires 04-24-07 1621ET

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