Federal Reserve chief Ben Bernanke provided cold comfort on Wednesday to those worried that the subprime mortgage mess will infect other areas of finance, though he lifted spirits in the bond market.
Bond traders took his heightened focus on the subprime problem as a sign that the U.S. central bank might have to consider cutting interest rates if fallout from the crisis spreads.
While there was no headlong rush into bets on monetary easing, traders took particular notice of Bernanke's mention of the social consequences of the subprime sector, which lends to borrowers with poor credit.
To me, if the Fed watches it, it means that they worry about it, said Nicolas Beckmann, co-head of dollar interest rate trading at BNP Paribas in New York.
When you piece the two together, the potential social impact of housing and potential economic impact, the Fed cannot ignore it. How they can respond to it is by easing.
In his prepared testimony, Bernanke said conditions in the subprime mortgage sector have deteriorated significantly.
He said increasing delinquencies and foreclosures were creating personal, economic, and social distress for many homeowners and communities -- problems that likely will get worse before they get better.
Bonds were initially indecisive as traders sifted through his comments on inflation, which reflected continued worries about the level of price growth in the face of high energy costs and a tight labor market.
However, bonds eventually turned strongly positive as the as the weight of the subprime theme sank in. The benchmark 10-year Treasury note
The testimony also followed weeks of topsy-turvy trade in financial markets over subprime worries, especially in recent days in the wake of warnings of downgrades to a slew of mortgage-backed debt by credit ratings agencies.
Bernanke's appearance came right after Bear Stearns told investors that two hedge funds it runs have been essentially wiped out by bad bets on subprime mortgage bonds.
In some ways the testimony was more remarkable for what it did not say. In particular, the prepared testimony did not emphasize the Fed's earlier view that the subprime troubles were contained to that segment of the market.
In fact, he noted there had been increased concerns among investors about credit risk on other types of financial instruments.
It does mark a little bit of a different tone, probably reflecting the concerns in the market, said Tony Crescenzi, chief bond market strategist at Miller, Tabak & Co in New York.
Perhaps he didn't say enough on subprime to alleviate concerns. The one take-away I think some people will get out of this is where he said that problems will likely get worse before they get better in subprime.
Bernanke did note, however, that even after the recent bout of unease, credit spreads remain historically tight. That could be seen as one signal that markets are not yet overly stressed.
However, some bond bulls were somewhat skeptical that the rally in the Treasury market could continue, given the Fed's tough stance on inflation.
Even though the Fed downgraded slightly its expectations for economic growth, traders said there was still nothing in the testimony to suggest the central bank would even consider a rate cut before price pressures such as low unemployment receded, despite the subprime concern.
The are concerned up to a point, but not enough to ease, said David Coard, head of fixed income sales and trading at Williams Capital Group in New York.