Wednesday, March 18, 2009

Bernanke Caps Treasury Yields to Cut Consumer Borrowing Rates

Federal Reserve Chairman Ben S. Bernanke may have brought an end to the worst quarterly start for Treasuries since 1980 by establishing a ceiling on yields with plans to buy $300 billion in government debt.

Treasuries lost 3.4 percent since December prior to yesterday’s announcement that the Fed would expand asset purchases to drive consumer borrowing rates lower, and were headed for their worst three-month period since the third quarter of 1980, when they fell 5.06 percent, Merrill Lynch & Co. index data show. Yesterday’s rally pared this year’s losses to 1.38 percent.

“The Fed is capping Treasury yields,” said David Glocke, who manages $65 billion of Treasuries at Vanguard Group Inc. in Valley Forge, Pennsylvania. “I don’t think we will see rates drift back up above three percent; everyone looks at that as being the ceiling.”

Treasury 10-year note yields fell the most since 1962 yesterday, dropping to 2.52 percent, after the Fed surprised investors by expanding the debt purchase portion of its quantitative easing policy, which already includes agency and mortgage debt, to about $1.75 trillion in securities.

While investors anticipated an increase in mortgage and agency debt purchases, firms including Goldman Sachs Group Inc., Morgan Stanley and UBS AG forecast that Bernanke would focus on expanding existing programs before buying Treasuries.

“We were a little surprised about the timing,” said Ira Jersey, head of interest-rate strategy at RBC Capital Markets in New York. “They have to get spreads on consumer rates down.”

Mortgage Rates

Central bankers and Treasury haven’t been able to meet Bernanke’s goal of reducing consumer interest rates along with the borrowing costs paid by banks.

The difference between rates on 30-year fixed mortgages and 10-year Treasuries was 2.1 percentage points yesterday, Bloomberg data show. That’s up from an average of 1.75 percentage points in the decade before the subprime mortgage market collapsed.

Investors have also shunned debt backed by consumer loans as unemployment has climbed in the worst financial crisis since the Great Depression. Sales of the bonds plunged 40 percent last year to $106 billion, according to data compiled by Bloomberg, choking off funding to lenders. About $2.3 billion of debt backed by auto loans has been sold this year, compared with more than $9.6 billion in the same period of 2008, according to data from JPMorgan Chase & Co.

Yield Ceiling

Ten-year Treasury yields tumbled 47 basis points yesterday to 2.53 percent after the Fed’s announcement. The note’s yield touched 3.02 percent yesterday and has failed to break 3.05 percent three separate times since March 4.

“If rates drifted to that level I’d be a buyer,” Vanguard’s Glocke said.

Investor concern about rising supplies of debt and stock gains had pushed yields up from record lows in the fourth quarter. Goldman Sachs estimates that Treasury sales will almost triple this year to as much as $2.5 trillion as President Barack Obama looks to finance a budget deficit that his administration forecasts may expand to $1.75 trillion.

The Fed said it will increase its purchases of agency debt this year by up to $100 billion to a total of as much as $200 billion and will buy $750 billion in mortgage-backed securities on top of the already-announced $500 billion program, according to the central bank’s policy statement. The Fed also said it will consider expanding the Term Asset-Backed Securities Loan Facility to include "other financial assets."

‘Reinforces the Case’

Bernanke first mentioned the option of buying longer-term Treasuries on Dec. 1. Less than three weeks later, 10- and 30- year yields touched record lows. The Fed trimmed the target rate for overnight loans between banks to a range of zero to 0.25 percent at the Dec. 16 meeting to help unfreeze credit markets.

"Our medium-term expectation of lower 10-year Treasury yields has been premised upon quantitative easing," JPMorgan Chase & Co. strategists led by Srini Ramaswamy wrote in a note to clients yesterday. "Today's FOMC statement reinforces the case for lower yield levels over a longer term horizon."

The Fed may also buy Treasury Inflation-Protected Securities, or TIPS, used by investors to guard against inflation. The purchases will begin "late next week" and will take place two to three times a week thereafter, according to a statement on the Fed Bank of New York’s Web site.

‘Exit Strategy’

"The big concern in Treasuries is, 'What will the Fed do if we see inflation coming back and what is the strategy for reversing these purchases,' said Mustafa Chowdhury, head of U.S. interest-rates research in New York at Deutsche Bank AG, one of 16 primary dealers that trade government securities with the Fed. “If a clear exit strategy is not spelled out for the market, it will cause a huge reaction."

The consumer price index climbed 0.4 percent after a 0.3 percent rise in January, the Labor Department said yesterday. Excluding food and fuel, the so-called core rate advanced 0.2 percent. The gains pushed the annual core inflation rate up to 1.8 percent, within the range that most Fed officials say is their objective.

"The Fed has employed its shock and awe policy," said Richard Schlanger, a vice president who helps invest $13 billion in fixed-income securities at Pioneer Investment Management in Boston. "This has to have a profound impact on credit spreads going forward."

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