Fed May Buy $300 Billion in Treasuries After QE2

Daniel Kruger and John Detrixhe, On Monday June 27, 2011, 7:15 am EDT

The Federal Reserve will remain the biggest buyer of Treasuries, even after the second round of quantitative easing ends this week, as the central bank uses its $2.86 trillion balance sheet to keep interest rates low.
While the $600 billion purchase program, known as QE2, winds down, the Fed said June 22 that it will continue to buy Treasuries with proceeds from the maturing debt it currently owns. That could mean purchases of as much as $300 billion of government debt over the next 12 months without adding money to the financial system.

The central bank, which injected $2.3 trillion into the financial system after the collapse of Lehman Brothers Holdings Inc. in September 2008, will continue buying Treasuries to keep market rates down as the economy slows. The purchases are supporting demand at bond auctions while President Barack Obama and Republicans in Congress struggle to close the gap between federal spending and income by between $2 trillion and $4 trillion.

“I don’t think the Fed wants to remove accommodation in any way, shape or form,” said Matt Toms, the head of U.S. public fixed-income investments at Atlanta-based ING Investment Management, which oversees more than $500 billion. “It’s quite natural for them to reinvest cash,” he said. “That effectively maintains the accommodative stance.”
Mortgage Debt

A total of $112.1 billion of the Fed’s government bond holdings will mature in the next 12 months, 7 percent of the $1.59 trillion in Treasuries held in its system open market account, known to traders as SOMA. Replacing those securities will require the Fed to buy an average of $9.4 billion of Treasuries a month through June 2012.

The Fed also held $914.4 billion of mortgage-backed debt and $118.4 billion of debentures, the debt of government sponsored enterprises Fannie Mae and Freddie Mac, as of June 22. UBS AG, Citigroup Inc., Bank of America Corp., JPMorgan Chase & Co. and Royal Bank of Canada say $10 billion to $16 billion will mature each month, depending on the pace of prepayments.
In a Bloomberg survey of 58 economists June 14-17, 79 percent said Fed Chairman Ben S. Bernanke will sustain the central bank’s balance sheet at current levels until the fourth quarter, compared with 52 percent in April. The Fed said June 22 its goal is to hold assets at $2.654 trillion.
Treasury 10-year yields fell to the lowest since Dec. 1 today, down from this year’s high of 3.77 percent on Feb. 9. On June 24, the two-year yield came within one basis point of the record low, set November 2010, reaching 0.32 percent.

Frustrated Fed
The yield on the benchmark 10-year note declined to 2.84 percent today, the least since Dec. 1, before settling at 2.86 percent. The 3.125 percent security due in May 2021 traded at 102 1/4 at 7:13 a.m. in New York, Bloomberg Bond Trader prices showed. Two-year yields were at 0.34 percent after reaching 0.32 percent last week, the lowest since Nov. 4.
Bernanke said at a press conference June 22 that progress bringing down the 9.1 percent U.S. unemployment rate was “frustratingly slow.”
Fed officials said the economy will expand 2.7 percent to 2.9 percent this year, down from forecasts ranging from 3.1 percent to 3.3 percent in April. It was the second time this year Fed officials lowered growth estimates. Gross domestic product expanded 3.1 percent last year.
Policy makers said they expect the world’s largest economy to grow 3.3 percent to 3.7 percent in 2012, according to their central tendency forecasts. In April, their predictions ranged from 3.5 percent to 4.2 percent.

Fear Factor
Fed officials predict an average unemployment rate of 8.6 percent to 8.9 percent in the final three months of 2011, compared with 8.4 percent to 8.7 percent projected in April. Their estimate for unemployment at the end of 2012 was in a range of 7.8 percent and 8.2 percent, compared with 7.6 percent to 7.9 percent in April.
While the Fed didn’t start a third round of quantitative easing, as some traders speculated was needed, Treasuries could gain on weakening of the economy or the European sovereign debt crisis.
“What always moves the market is fear and greed, and there’s a huge amount of fear on the economy,” said David Brownlee, head of fixed income at Sentinel Asset Management in Montpelier, Vermont, which manages $28 billion. “That’s where you want to have Treasuries.”
The conflict between Obama’s administration and Congress over increasing the government’s borrowing limit could lead to higher yields, as Moody’s Investors Service and Standard & Poor’s said they may consider cutting the nation’s AAA credit rating unless progress is made next month.

Debt Ceiling
 Vice President Joe Biden’s bi-partisan deficit-reduction group has been meeting since May 5 to reach a compromise that would trim long-term deficits by as much as $4 trillion and clear the way for a vote in Congress to raise the $14.29 trillion debt ceiling. Treasury Secretary Timothy F. Geithner has said the U.S. risks defaulting if the limit isn’t increased by Aug. 2.
The 10-year Treasury note’s yield will reach 4 percent by June 2012, according to the median of 64 forecasters in a Bloomberg News survey. The last time it reached 4 percent was April 2010. Should that happen, investors would lose 5 percent on their investment, Bloomberg data show.
“Up until now, our assumption was that the risk is virtually zero of them ever missing an interest payment,” Steven Hess, Moody’s senior credit officer, said in an interview June 21. “If they actually miss a debt payment, then it’s a fundamental change.”

Record Auction Demand
So far, there’s been no lack of demand for government securities even as public Treasury debt has grown to $9.26 trillion from $4.5 trillion at the start of the financial crisis in August 2007, and $5.75 trillion when Obama took office in January 2009.
 
Investors have bid a record $3.01 for every dollar of debt sold by the Treasury this year, compared with $2.99 last year and $2.50 in 2009. The average 10-year yield this year of 3.32 percent compares with a 20-year average of 5.17 percent.

The Fed won’t raise its zero to 0.25 percent target rate for overnight loans between banks until the first quarter of next year, according to the weighted average forecast of 71 analysts surveyed by Bloomberg.
“The economic recovery is continuing at a moderate pace, though somewhat more slowly than the committee had expected,” Fed policy makers said in a June 22 statement. While the labor market has been “weaker than anticipated,” the impact of higher food and energy prices on consumption is likely to be “temporary,” officials said.
Inflation Expectations
Yields on 10-year Treasury Inflation Protected Securities show bond traders project an average 2.2 percentage point inflation rate during the life of the debt, up from 1.5 percentage points in August 2010, when Bernanke first indicated the central bank might resume debt purchases to fight deflation. QE2 also succeeded in driving investors into riskier assets. The Standard & Poor’s 500 Index has gained 22 percent during the period.
The Fed began its first round of quantitative easing in November 2008 after the collapse of Lehman and the central bank’s $85 billion bailout of insurer American International Group Inc. with a program to buy $500 billion of mortgage securities and $100 billion of agency debentures. In March 2009 it boosted planned purchases to include $300 billion of Treasuries and raised its target for mortgage debt to $1.25 trillion and $200 billion of government agency bonds.
Asset purchases, even at a smaller scale, “still promotes what the Fed was trying to accomplish,” said Tony Crescenzi, a money manager and strategist at Newport Beach, California-based Pacific Investment Management Co., which runs the world’s biggest bond fund. “Even with the stoppage of QE2, the fundamental forces remain intact.”
To contact the reporters on this story: Daniel Kruger in New York at dkruger1@bloomberg.net; John Detrixhe in New York at jdetrixhe1@bloomberg.net
To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net

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