Jumping U.S. yields may force Fed wallet open wider

By Ellen Freilich and Julie Haviv - Analysis

NEW YORK (Reuters) - The Federal Reserve has been buying Treasuries to improve lending conditions, but the recent rise in bond yields could be a signal that the U.S. central bank may need to continue to intervene to offset massive government debt issuance.

In March, the Fed said it would buy up to $300 billion of Treasuries over the next six months, and it has purchased about a third of that allocation so far. The Fed is expected to complete those purchases by the end of the six-month period.

But long-term Treasury yields have risen recently as investors have reacted to additional government sales, and the massive projected government deficit could make investors wary of purchasing more bonds. Many analysts believe the Fed will seek to offset this to try to keep mortgage rates low, a key component in stimulating economic growth.

"We have always viewed the $300 billion pledged for purchases of Treasuries as a starting point, not as an ending point," said Ira Jersey, group head of U.S. interest rate strategy at RBC Capital Markets in New York.

"The Fed needs to do more quantitative easing and our current estimate is that the purchases of Treasuries could go as high as a trillion dollars," he said.

The Fed's Treasuries purchases, while significant, are only a small part of its efforts to ease lending conditions.

The Fed has aggressively used its balance sheet to flush credit through the economy, boosting the size of the balance sheet from $800 billion to more than $2 trillion, noted Paul Sheard, managing director and global chief economist at Nomura Securities International in New York.

The balance sheet expansion is one part of a government policy that includes bank stress tests, the Public Private Investment Partnership, or PPIP, for toxic assets, and fiscal stimulus, he added.

The central bank has purchased about $600 billion of the $1.75 trillion pledged for efforts to lower borrowing costs for consumers. Initially, these programs, which include purchases of agency mortgage-backed securities and agency debt, helped reduce mortgage rates, but that momentum has stalled, and rates are at their highest in nearly two months.

"In order to maintain a 4 percent agency mortgage rate, the Fed will likely have to step up its daily purchases of Treasuries and focus more on the longer end of the curve," Bill Gross, co-chief investment officer of bond giant Pacific Investment Management Co, said Friday in an email response to a question from Reuters.

RATES ON THE RISE

The sudden rise in Treasury yields could complicate the push to lower rates. The Mortgage Bankers Association said borrowing costs on 30-year fixed-rate mortgages, excluding fees, averaged 4.79 percent for the week ended May 1, up 0.17 percentage point from the previous week. It was the highest since 4.89 percent in the week ended March 13 though well below year-ago levels of 5.91 percent.

The Fed has attempted, through its purchases, to influence rates in both the mortgage-backed securities market and the Treasury market. Through purchases of about $20 billion to $30 billion per week, the Fed has managed to drive the yield on par priced agency MBS to their narrowest yield difference to the 10-year Treasury note since January 1994, according to Kevin Cavin, mortgage strategist at FTN Financial Capital Markets, in Chicago.

The same cannot be said for the central bank's influence in the $6 trillion Treasury market. At 3.29 percent, 10-year Treasury yields are 30 percent higher than where they stood when the Fed first made its Treasury purchase announcement in March.

While $300 billion in purchases is sizable, "it doesn't seem like so much when the Treasury is borrowing $2 trillion," said Stone & McCarthy Research Associates economist Ward McCarthy in Princeton, New Jersey. "Such massive borrowing requires somewhat higher rates to attract investors in order to absorb this massive supply."