Friday, May 29, 2009

Fed Holds Steady as Rates Rise in Market

By JON HILSENRATH and LIZ RAPPAPORT WASHINGTON -- Federal Reserve officials believe the recent sharp rise in yields on U.S. Treasury bonds could reflect a mending economy and a receding risk of financial catastrophe, suggesting the central bank won't rush to react -- even though some investors see danger in the government's rising cost of borrowing. Bond markets continued to gyrate Thursday after a sharp run-up in 10-year Treasury yields the day before. The bond market pushed yields of 10-year Treasurys down to 3.674% from 3.70% Wednesday, but they remain well over mid-March's 2.5% level. Yields on mortgage-backed securities continued to climb, pushing 30-year fixed-rate mortgages to 5.44%, the highest since early February. The Fed has embarked on a massive effort in recent months to buy Treasurys and mortgage-backed securities, a bid to drive up their prices and push down yields. It aims to keep borrowing costs low, hoping cheap mortgages in particular will spur the still-weak economy. Its purchases also provide the financial system with money it hopes banks will lend, part of an approach some call quantitative easing. The Fed could eventually decide to step up bond purchases to restrain long-term rates, a question Fed officials will confront at their June 23-24 meeting. So far, the Fed has purchased $130.5 billion of the $300 billion in long-term Treasury debt it began buying in March. It also has bought $481 billion in mortgage-backed securities and has said it could buy as much as $1.25 trillion worth. "The market believes that the Fed will expand its purchases of mortgage-backed securities and Treasurys," said Ronti Pal, head of U.S. interest rates trading at Barclays Capital. "But the longer it takes the Fed to do so, the more the market overwhelms the Fed's efforts and the risk increases for an even sharper rise in yields." Fed Chairman Ben Bernanke, in testimony to Congress earlier this month, emphasized the Fed is not trying "to target a particular interest rate," despite market speculation to the contrary. Fed officials viewed the rise in Treasury yields in March and April as largely benign. In their most recent policy meeting, in late April, Fed staff concluded the rise was tied to "the improved economic outlook, an easing of concern about financial institutions and perhaps some reversal of flight-to-quality flows," according to minutes of the meeting. In other words, the Fed was heartened that investors were moving out of the safe haven of Treasurys and into riskier investments. Journal Community Vote: Do you think the economy is on the mend? Share your thoughts at Journal Community. At that meeting, Fed policy makers decided "to see how the economy and financial conditions respond to the policy actions already in train before deciding whether to adjust the size or timing of asset purchases," the minutes said. But the surge in yields has forced the central bank to re-examine what has driven it, whether it needs to be addressed, and, if so, how. The Fed could view rising yields more as a sign of healing -- an indication that investors are willing to leave the safety of U.S. Treasury securities for other securities, or a sigh of relief that deflation appears less of a worry. If this is the case, the Fed is unlikely to respond aggressively to restrain yields. Or, Fed officials could see the bond market as endangering the economy by prematurely pushing up yields because of market dysfunction or unfounded fears of inflation. In this case, it could ramp up its purchases. Fed officials have watched private-sector borrowing rates. They hope their various programs will narrow the difference, or spread, between low-risk Treasury bonds and riskier assets -- like junk bonds or mortgage-backed securities -- and in turn spur more economic activity. While yields on mortgage securities are moving higher, those on corporate borrowing aren't. Yields on Baa-rated corporate bonds have fallen from 9.20% since March, when Treasurys hit a low, to 7.80%. The narrowing gap is seen as one of several signs that credit markets are gradually improving. At the same time, markets are pushing up mortgage rates. The Fed bought $25 billion in mortgage-backed securities through the week ended Wednesday. But as investors sell, the gap between yields on mortgage-backed securities and comparable Treasurys widened about 1.69 percentage points Thursday from 1.33 points a week ago, according to FTN Financial. "This has turned into a two-day sell-off, which is unusual," said Kevin Cavin, an FTN strategist. Over the past six months, any significant widening on a single day has been followed by a tightening as mortgage-security yields catch up with a movement in Treasury rates. "Today is different. This is at odds with what the Fed is trying to do." The Fed may be reluctant to step up mortgage-securities purchases because it doesn't want to crowd out the market's other investors. In addition, some Fed officials worry that an expansion of Fed purchases could make it difficult for the Fed to back away from its extraordinary actions when the economy recovers. Among the more benign explanations of the bond market's gyrations is the sense that the odds of a dangerous bout of deflation, in which prices and wages fall, are waning. Movements in inflation-indexed Treasury securities suggest that expected inflation over the next 10 years has moved up from near zero early in the year to nearly 2% today -- roughly the Fed's target. But bond markets may be expressing worry over the government's borrowing to finance its large budget deficit. The White House anticipates the deficit will reach $1.8 trillion this fiscal year. President Barack Obama's budget would add $7 trillion to the federal debt load through 2019. The Obama administration Thursday downplayed market fears about excessive federal borrowing, insisting that Mr. Obama has a credible long-term plan to curb the deficit. Some Fed officials worry that ramping up Treasury purchases could be read by investors as a sign that the central bank is willing to finance government budget deficits to the point where it could spark inflation or trigger a decline in the dollar. Officials see the next big Treasury auction of three-, 10- and 30-year Treasury debt in early June as a test of how much debt world markets can digest. The auction's size will be announced next week. —Jonathan Weisman contributed to this article. Write to Jon Hilsenrath at jon.hilsenrath@wsj.com and Liz Rappaport at liz.rappaport@wsj.com

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