Eager Fed Helps Keep Treasury Rally Strong

By TOM LAURICELLA Defying conventional wisdom, the market for U.S. government debt is rallying thanks to an unusual combination of buyers including American households, banks and the Federal Reserve. The rally has taken Treasury yields -- which move opposite the bonds' price -- to their lowest levels since spring, and have helped push mortgage rates to their lowest levels in three months. The Fed's active presence has also raised questions of whether the rally is sustainable. The appetite for Treasurys, generally considered safe, points to an undercurrent of wariness about the health of the economy long term, even as investors have lately loaded up on riskier investments, like stocks and junk bonds. Typically, stocks and other risky investments move in the opposite direction of Treasurys in the short term. "We've seen a breakdown in the normal relationships between risk assets and riskless assets," says William O'Donnell, head U.S. Treasury strategist at RBS Securities. The yield on the U.S. Treasury 10-year note fell to 3.3%, from nearly 3.9% on Aug. 7, near its highs for 2009. The yield on the 30-year bond, meanwhile, dropped below 4.1% from 4.6% in early August. The buying has defied worries that the U.S. government's borrowing binge would overwhelm demand for government bonds. This week the government is scheduled to auction a record $112 billion in debt. The Fed, bent on keeping the economy chugging through low rates and functioning credit markets, has been one of the biggest buyers of both U.S. Treasurys and government-backed mortgage debt. In effect, it has printed money to support stimulus efforts. In the second quarter, the most recent for which data is available, the Fed bought $164 billion out of the $339 billion in net new Treasurys sold. In the mortgage-backed debt markets, the Fed has been buying upward of 80% of the bonds issued by agencies such as Freddie Mac and Fannie Mae. Net issuance of fixed-income securities in the U.S. after the Fed's purchases is likely to have fallen by 25% in 2009 from last year to $843 billion, according to Barclays Capital estimates. The Fed is slated to stop buying Treasurys at the end of October. And traders say a much bigger test will come when the Fed stops vacuuming up mortgage-backed debt, removing a big prop to the real-estate market. "The government is borrowing all this money but the Fed is taking an enormous amount out," says Ajay Rajadhyaksha, head of U.S. fixed-income strategy at Barclays. Still, observers say many buyers believe inflation will remain low for years to come, making Treasurys -- which offer a fixed payment regardless of the movement of prices -- a good bet. Some "view the economic recovery as being very anemic," says Mary Ann Hurley, a trader at D.A. Davidson & Co. Individual investors are among those gorging on Treasurys this year, data released by the Federal Reserve suggest. Households directly owned $606 billion worth of U.S. Treasurys, up from $576 billion at the end of the second quarter and $240 billion at the start of the year. That figure includes hedge funds, but analysts believe the buying binge has been more at the hands of individuals. By comparison, holdings out of China -- a figure that has been closely watched for signs of change -- were essentially flat in the second quarter, rising to $776 billion from $768 billion. Analysts believe the trend of U.S. households buying Treasurys has extended through the third quarter as investors migrate away from money-market funds, which are yielding a record low of 0.06%, according to iMoneyNet. In some ways, moving from short-term bills to longer maturity Treasury notes is in keeping with the greater willingness among investors to shift money out of super-safe investments, says Tony Crescenzi, a portfolio manager at Pimco. "It may not be 'risky'...but there's a risk to purchasing a five-year note instead of owning a money-market fund." The Fed is slated to stop buying Treasurys at the end of October. And traders say a much bigger test will come when the Fed stops vacuuming up mortgage-backed debt, removing a big prop to the real-estate market. Above, the Federal Reserve building in Washington last month. Financial institutions, particularly U.S. regional banks, have provided another leg of demand for U.S. government debt. As financial institutions seek to shore up their balance sheets, they're buying debt securities rather then lending. Banks have tended to own a higher proportion of mortgage-backed debt guaranteed by agencies like Fannie Mae and Freddie Mac, especially in recent years. But the Fed's buying of that debt has helped drive yields so low that many banks who would normally buy that debt are instead buying Treasurys. While Treasury yields are still slightly lower than those offered by mortgage-backed debt, banks aren't required to hold capital against their holdings of Treasurys securities, unlike debt guaranteed by Fannie or Freddie. This unlikely rally is a plus for the battered housing market, and thus the economy at large, because mortgage rates closely track Treasury yields. The rate on the average 30-year-year fixed mortgage rate fell to 5.04% last week, hovering at its lowest levels in three months. That in turn has helped lift interest in mortgage refinancings. During the week of Sept. 4, the Mortgage Bankers Association Refinance Index increased 22.5% from the previous week, the biggest jump since mid-March. By late last week the Treasury rally did ebb some. Short-term players took profits and dealers prepared for the Treasury auctions this week, which are often preceded by a softening of prices. The 10-year finished last week at just less than 3.5%, and the 30-year at 4.2%. Write to Tom Lauricella at tom.lauricella@wsj.com