Treasuries rally as Fed buys anticipated

NEW YORK (Reuters) - U.S. Treasuries rallied on Monday as the 30-year bond led shorter-dated debt higher, flattening the curve in low volume trade as markets anticipated the next round of Federal Reserve asset purchases.

The 30-year bond was up 26/32, its yield easing to 3.89 percent from 3.93 late on Friday.

The 30-year bond had been underperforming shorter maturities on the presumption that the Federal Reserve would concentrate its securities purchases among shorter maturities in the middle, or belly of the curve.

“The market is embracing QE2 (the second phase of quantitative easing) this morning with the Fed’s announcement just over a week away,” said Chris Rupkey, chief financial economist at Bank of Tokyo/Mitsubishi UFJ in New York.

“A consensus is starting to form around the $100 billion level of purchases to be made incrementally between the November and December (Federal Open Market Committee) meetings, and a number of that magnitude could lead to a shortage of supply,” he said.

The thought of a shortage is also fed by the weak dollar, which “is prompting a lot of Treasury purchases by Asian central banks,” Rupkey said.

“People are also pointing to another Goldman Sachs Monday morning missive talking about large quantitative easing purchases to restart the fading economic recovery,” he said.

In an e-mail sent Friday evening, Goldman Sachs said the FOMC is almost certain to announce renewed monetary easing at its November 2-3 meeting.

“We expect an announcement of $500 billion or perhaps slightly more over a period of about six months, although it could be packaged in terms of a comparable monthly rate,” the note said.

“The key question, however, is not the size of the first step, but how far Fed officials will ultimately need to move to achieve their dual mandate of low inflation and maximum sustainable employment,” Goldman said, adding that estimating the purchase target was “challenging.”

Goldman said that combining its estimated Taylor-style rule with its economic forecasts shows that the warranted federal funds rate is “deeply negative.

“Taken at face value, our estimates imply that the zero bound has kept the funds rate around 700 basis points ‘too high,’” Goldman said.

“Although the uncertainty is very large, our analysis is consistent with additional asset purchases of around $2 trillion if the FOMC’s forecasts converge to our own,” it said.

Goldman said if all other policy levers stay where they currently are, Fed officials would need to buy an additional $4 trillion in assets “to fully close the policy gap,” but added that in reality, the FOMC is unlikely to authorize additional large-scale asset purchases of as much as $4 trillion “unless the economy performs much worse than we are forecasting.”

Market participants said volumes were likely to remain thin all week ahead of the FOMC meeting.

Traders said maturities in the belly of the curve could slightly underperform longer-dated maturities as the Treasury sells a total of $109 billion of coupon-bearing two, five and seven-year notes, starting with a reopening of $10 billion of five-year Treasury Inflation-Protected Securities on Monday.

Fed Chairman Ben Bernanke’s welcoming remarks at a conference in Arlington, Virginia had no discernible market impact. New York Fed President William Dudley will speak later in the session.

The benchmark 10-year note rose 14/32, its yield easing to 2.51 percent from 2.56 percent on Friday.

Editing by Padraic Cassidy