Fed May Concentrate Treasury Purchases in Most Recent Issues

By Daniel Kruger

March 24 (Bloomberg) -- The Federal Reserve is likely to target the newest, most-traded Treasury securities for purchase to maximize the effect for lowering borrowing costs for consumers, according to fixed-income strategists at JPMorgan Chase & Co., UBS AG and Wrightson ICAP.

The central bank may announce as early as today which maturities it will buy as part of its plan to acquire $300 billion of Treasuries during the next six months and expand purchases of mortgage bonds sold by government-sponsored enterprises such as Fannie Mae and Freddie Mac to $1.25 trillion from $500 million. The Federal Reserve Bank of New York, which conducts market transactions for the Fed, said March 18 it would target maturities between two and 10 years.

Investors have 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 as of last week, compared with more than $9.6 billion in the same period of 2008, according to data from JPMorgan Chase & Co.

“The goal of this is to lower the benchmark rates of which spread products are priced,” Louis Crandall, chief economist at Jersey City, New Jersey-based research firm Wrightson ICAP. “To do that that you want to be buying either the on-the-runs or close substitutes.”

‘Off-The-Runs’

The yield on the 10-year Treasury has risen 12 basis points to 2.65 percent following the Fed’s announcement of the purchase plan. Yield on the securities tumbled 47 basis points after the buyback announcement, the biggest one-day rally since 1962. Two- year government note yields have climbed about eight basis points to 0.89 percent.

“There’s a strong incentive on their part to buy on-the- runs,” or the most recently auctioned securities, said Michael Feroli, an economist at JPMorgan and former staffer at the Fed.

The difference in yield between older, higher coupon Treasuries and new issues has already narrowed on the Fed’s buyback plan. The spread between the 8.875 percent Treasury sold in 1989 and maturing in February 2019 and the 10-year benchmark 2.75 percent note sold last month contracted to 25 basis points yesterday from 39 basis points on March 17.

The central bank will probably concentrate its purchases in the seven- to 10-year part of the market because that is where hedging activities are concentrated, Feroli said.

Record Auctions

Buying older, higher coupon off-the-run Treasuries would allow investors to rid themselves of harder-to-trade debt and deploy the proceeds elsewhere, said Chris Ahrens, an interest- rate strategist at UBS Securities LLC in Greenwich, Connecticut, one of the 16 primary dealers that trade with the Fed.

“You’ve accomplished what they want to do, which is buy back debt, and what you want to do, which is get liquidity onto your balance sheet,” Ahrens said.

The Fed’s purchases may boost demand as the Treasury prepares to auction a record $98 billion of notes this week, surpassing the $94 billion record set the week ended Feb. 27. The government will sell $40 billion of two-year notes today, $34 billion of five-year debt tomorrow and $24 billion of seven- year notes the following day.

Government debt sales will almost triple this year to a record $2.5 trillion, according to estimates from Goldman Sachs Group Inc.

Kennedy Administration

President Barack Obama’s administration is seeking congressional approval for a budget of $3.55 trillion for the fiscal year beginning in October.

The nonpartisan Congressional Budget Office estimated the 2010 deficit at $1.38 trillion, higher than the White House’s $1.17 trillion projection.

The Fed last purchased Treasuries in an effort to impact interest rates in early 1961, when President John Kennedy launched Operation Twist to raise short-term interest rates while simultaneously lowering long-term rates, according to a 2004 paper written by Fed Chairman Ben S. Bernanke. The policy employed the Fed’s open market operations desk, as the current policy is also intended to do.

To contact the reporter on this story: Daniel Kruger in New York at dkkruger1@bloomberg.net.