Bond prices jump on aggressive rate cut hopes

NEW YORK (Reuters) - Government bond prices rose on Monday, pushing short-dated yields to two-year lows on optimism the Federal Reserve would aggressively cut interest rates next week.

Wall Street stocks ended little changed.

Treasuries extended Friday's hefty gains triggered by an unexpected drop in nonfarm payrolls, with the 30-year bond rallying more than a full point in price.

August's jobs report left traders certain the Fed would cut the benchmark overnight lending rate at its September 18 meeting, with a growing chorus now expecting the federal funds rate target to be lowered by 50 basis points to 4.75 percent.

"People are coming to the view that ... perhaps 50 basis points is not out of the question," said Wan-Chong Kung, senior fixed income portfolio manager at First American Funds in Minneapolis.

In late New York trade, benchmark 10-year notes traded 14/32 higher in price for a yield of 4.33 percent, versus 4.39 percent late on Friday. Yields, which move inversely to prices, earlier fell as far as 4.30 percent -- the lowest since early 2006.

Two-year notes, the most sensitive to changing views on Fed interest rate policy, were up 3/32 to yield 3.85 percent. Yields briefly dropped to 3.82 percent, a level not seen since late 2005.

Two-year yields have fallen nearly 75 basis points since the end of July.

Traders said the market also took heart from comments by San Francisco Federal Reserve Bank President Janet Yellen that the current financial market turmoil had added "appreciably" to downside risks for the U.S. economy.

They were equally cheered by Atlanta Federal Reserve Bank President Dennis Lockhart's stepping back from his views last week that the downturn in the housing market had so far clearly not affected the broader economy.

"It's a carry-over from Friday's job report. A couple of Fed speakers made comments about seeing the economy weaken. Treasuries are benefiting from all that," said David Coard, head of fixed-income sales and trading at Williams Capital in New York.

But Coard said yields were starting to look expensive at current levels.

"It's almost like we have discounted some Fed moves. These levels are also based on the flight-to-quality bid, which is not always rooted in economic data, but more on the fear in the market place that some problem might be lurking out there," he said.

"These levels, on the basis of the fundamentals are probably overbought here, so I would be reluctant to say we will go much further than this."

Stocks briefly swung into positive territory but ended flat as troubles in the housing sector continued to overshadow the market. For details, see .N]

The 30-year bond US30YT=RR gained 32/32 in price and yields tumbled as far as 4.62 percent, the lowest since March. Five year notes jumped 9/32 in price, pushing yields down as far as 3.96 percent, a two-year low.

Elsewhere on the fixed income market, interest rate swap spreads were mixed. Ten-year swap spreads contracted to 65.25 basis points, versus 65.75 basis points late on Friday.

Two-year spread widened to 77.25 basis points from 75.75 basis points.