Fed may still buy Treasurys, just not now

NEW YORK (MarketWatch) -- The Federal Reserve is likely to hold off on using one of its last weapons to get credit flowing -- buying back Treasury securities from the open market -- because it has already made progress driving interest rates down in markets that would benefit from such a step, investors and strategists say.
When the Federal Open Market Committee releases ita statement on interest-rate policy Wednesday afternoon, culiminating a two-day meeting, members may hew closely to January's statement -- saying, namely, that the Fed retains the option of purchasing Treasurys if conditions warrant.

For the last four months, the Fed has discussed buying Treasurys to exert pressure designed to lower rates on the many corporate, mortgage and consumer loans linked to benchmark government debt. But at the same time, mortgage rates have fallen by a half percentage point, probably thanks to the Fed's purchases of mortgage-related assets.

That drop, according to observers, has had the effect of reducing any sense of urgency about proceeding with Treasury purchases.

"I don't think they will buy Treasurys," said Andrew Harding, chief investment officer in fixed income at Allegiant Asset Management.

"I think they're doing pretty darn well buying mortgages directly," he said.
Keeping their Treasury plans vague would also give Fed officials time to see if similar plans announced last week by the Bank of England and the Swiss National Bank bear fruit, and how markets respond to earlier programs and the swelling issuance of government debt. It has good reason to tread carefully: Buying Treasurys on the open market could lead to higher inflation -- the enemy of Fed and bondholders alike.

For now, the Fed may not feel pressure to tamper with Treasurys because yields are still historically low.

Yields on 10-year notes, widely considered one of the maturities the Fed may buy, have risen only moderately, to 2.97%. This compares to a 2.72% yield in early December, when Fed chief Ben Bernanke first brought up the possibility of Treasury purchases.

But the FOMC may again bring up purchases as a possibility, as the central bank has in recent statements.

"The Fed doesn't want to rule anything out, and they want to keep their options open," said Michael Pond, Treasury strategist at Barclays Capital.

A sharp rise in yields coinciding with a plunge in Treasury prices, perhaps sparked by the Fed's massive debt issuance this year, could be the tipping point for the Fed to buy government debt.

"They would probably consider it if 10-year yields went up considerably," Pond said, adding that it's uncertain if that level would be 3.50% or 4%. "But it's certainly not 3%," he said.

Lots of talk

At its last policy meeting on Jan. 28, the FOMC said it stood "prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets."

Ten-year yields ended that day at 2.66%, having rebounded somewhat from much lower levels at the end of 2008, when Treasurys benefited from a massive flight to safety amid a darkening economic outlook and a spreading contagion in financial markets.

Treasury yields have continued to rise as the government is almost constantly auctioning more debt to finance all its recovery efforts, making investors demand higher rates to hold the debt.

Still, Bernanke seemed to back off the inclination to buy Treasurys in testimony during congressional hearings earlier this month. He didn't even mention it in his prepared remarks on March 3.

Asked why he didn't want to start buying Treasurys after the previous FOMC meeting, Bernanke responded: "You have to solve the problem you've got" -- a reference to the mortgage securitization market.

Mortgage rates fall

Indeed, the New York Fed jumped into that market and started buying debt sold by the big mortgage finance agencies, including Fannie Mae and Freddie Mac, in January. It also started buying the mortgage-backed securities bundled by the agencies.

So far, the Fed has bought a total of $217 billion in mortgage-backed securities, according to market researcher Wrightson ICAP. That's not quite half the amount it originally said it would spend in that market.

Both steps positioned the Fed as buyer in secondary mortgage markets that had seized up but are vital to enabling lenders to make new mortgages. Lenders sell many of their loans to institutional investors, and higher rates charged by these investors to hold pooled mortgage loans make it harder for originators to offer lower rates on new mortgages.

In a sign that the purchases are driving down rates and encouraging private investors to also step in, the gap's dropped in just a few months between Treasurys and the rates that the agencies and mortgage-backed securities have to carry to make them attractive.

Yields on mortgage-backed debt dropped to 0.87 of a percentage point more than Treasurys, down from 1.90 points in December, and are near the lowest seen since late in 2007, according to a Merrill Lynch index.

Agency debt spreads, meanwhile, have fallen to 0.76 of a point from 1.05 points in mid-December, according to Merrill. That makes it that much cheaper for the housing entities to fund their purchases of individual mortgages and securitize them into bundles more desirable to many more investors.

"It's given a great deal of stability to mortgage markets, and a lot of confidence is building in that asset class," Harding of Allegiant said.

Lower capital-markets costs for mortgage originators and the mortgage agencies have helped drive down interest rates charged on home loans.

Thirty-year rates fell to 5.03% in the most recent week from 5.53% in early December, according to averages compiled by Freddie Mac. And the rates on 15-year mortgages -- popular for refinancing homes, something else the Fed wants to encourage -- also have dropped dramatically, to 4.64% from 5.33%, in the same time.

If yields rise...

Still, some say the Fed should still consider buying Treasurys directly from the market -- not just at the government's auctions, as it does now to manage its accounts.

Such an action would help lower mortgage rates further, by bringing down the yield those spreads are based on, as well as help the myriad of other securities and markets that are priced off Treasurys, including corporate bonds.

"It can help cap yields because all risk spreads go off Treasurys, so it would serve as an anchor pulling everything down," said Max Bublitz, chief strategist at SCM Advisors.

"It's inevitable that it's going to come," he said.

If that's so, the only question is at what yield would the Fed to deem it necessary to intervene or what other conditions would need to be in force. Conviction about the inevitability of intervention may alone be serving as a cap on bond yields.
"Why tip your hand when you don't need to?" Bublitz asked.

One of the factors that may push yields up to that point could be the Treasury Department's continued need to issue debt: Analysts expect more than $2 trillion in U.S. debt could be sold in fiscal 2010, the fiscal year that started last October.
That could shoot even higher if Congress approves further stimulus funding of some kind, said David Glocke, head of Vanguard's Treasury and taxable money-market group.

"If it looks like Congress will pass another stimulus package, the additional supply in the pipeline will force interest rates higher and increase the risk that the Fed steps in to set a ceiling," he said.

For their part, congressional leaders have given mixed signals as to how seriously they might embrace further stimulus following the recent enactment of a $787 billion package.

Testing the waters

The Fed also has the luxury of watching how its overseas counterparts fare in their effort to bring rates lower by buying debt from the secondary market.
Britain's central bank began buying U.K. debt last week, buying 2 billion pounds worth. The debt, known as gilts, rallied following the announcement, pushing 10-year gilt yields down to 2.97% from 3.64% before the announcement. See previous story on U.K. purchases.

Those kinds of improvements "will encourage the Fed to keep this potent option on the table," said Tony Crescenzi, chief bond-market strategist for Miller Tabak & Co.

The Swiss National Bank also said last week it would begin buying franc-denominated corporate bonds. See previous story on Swiss central bank plans.
The act of a central bank buying its own government's bonds is usually taken on as a way of further lowering borrowing costs once the central bank has already lowered its benchmark rate virtually as much as possible.

The concern is that the practice could ultimately lead to higher inflation, which makes it harder for businesses to grow and erodes the value of bonds' fixed returns. The Fed has to weigh that risk with its desire to help the U.S. economy out of a possibly severe recession.

For Bernanke and the FOMC, the most immediate risk now lie in managing expectations. Ahead of the last meeting, the bond market expected the Fed to take steps toward buying Treasurys.

It was disappointed when the Fed simply talked about it.
"What doesn't work is just saying that details will follow," Harding said.

By Deborah Levine, MarketWatch

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