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Don't fight the Fed

Fri, Mar 20 2009, 10:35 GMT
by Signe Roed-Frederiksen

Danske Bank A/S

• While we believe that long-term Treasury yields are set to rise as the financial and economic backdrop improves, the Fed's bold move to buy up Treasuries is likely to put a "cap" on yields and we expect Treasuries to range trade in the short term.
  
• However, given our expectations of a stabilisation in the economy by late Q2 we should continue to receive indications that the worst of the contraction in activity is behind us. This should make the Fed more hesitant to scale up quantitative easing further.
  
• With the "Bernanke put" in the Treasury market exhausted, any hints from the Fed that the easing cycle is coming to an end could result in a major surge in yields. We therefore recommend investors with a longer investment horizon to use the current setback in yields to open short positions at the longer end of the curve or to move into steepening trades.
  
• The Fed decision has also fuelled increased speculation of ECB buying government bonds down the road. We still believe that the ECB is miles away from seriously contemplating the buying of government bonds.

Another aggressive move from the Fed

The Federal Open Market Committee (FOMC) took yet another aggressive move at their meeting Wednesday evening, committing to purchase up to USD 300bn in longer-term Treasury securities over the next six months, concentrated in the 2- to 10- year sector of the nominal Treasury curve. This corresponds to between 20-30% of the gross issuance in the coming six months.

In addition, the Fed will expand its MBS purchase programme by USD 750bn to a total of USD 1,250bn and increase its purchase of agency debt by up to USD 100bn to USD 200bn. The Fed also scaled up on the rhetoric on the interest rate stating that the Fed funds rate would be held exceptionally low for an "extended period" compared to "for some time" at the January meeting.

Following the announcement, the 2-10 curve flattened substantially with 10-year Treasury yields dropping by more than 40bp, while the 2-year segment moved 16bp lower. Mortgage yields followed 30-year Treasuries down and 30-year Freddie Mac investor rates dropped to 4.25%.

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Published on  Fri, Mar 20 2009, 10:42 GMT