Fed to ease debt purchases, holds rates steady - Forecasts gradual resumption of growth

Published: Friday | August 14, 2009

US Federal Reserve Chair-man Ben Bernanke.

The United States Federal Reserve said Wednesday it would wind down its purchases of government debt, sparking a sell-off, but was more optimistic on the economy and opted to hold interest rates steady, sending stocks higher.

Investors moved out of Treasurys, sending yields higher after the central bank said it would slow its buying of government debt in the coming weeks in order to hit its target of purchasing US$300 billion in Treasurys by the end of October.

The Fed's more upbeat tone on the economy, meanwhile, spurred buying in the stock market, further chipping away at demand for the safety of Treasurys.

Treasurys had already been falling ahead of the conclusion of the Fed's two-day policy meeting Wednesday afternoon, as investors worried that the central bank wouldn't extend its Treasury purchase programme.

Lacklustre demand at an auction of US$23 billion in 10-year notes earlier in the day was a clear signal that investors were hesitant to buy Treasurys ahead of the Fed's decision.

Economic activity

The central bank said economic activity is leveling out and that there would be "a gradual resumption of sustainable economic growth."

As expected, the Fed left its federal funds rate at a record low of near zero.

Following the Fed's announcement, and as the Dow Jones industrials soared 120 points, the benchmark 10-year Treasury note fell 12/32 to 95 4/32, driving its yield up to 3.72 per cent from 3.67 per cent late Tuesday.

The Fed has committed to buying US$300 billion of Treasurys this year to help offset the overwhelming amount of debt being sold to fund the government's economic stimulus programmes.

Investors have been concerned that at some point, demand for government debt, especially from foreign investors, will diminish.

The fact that the Fed, come October, will no longer help counteract some of the supply coming to market is a concern to investors, although many have expected the central bank to start scaling back its purchases.

Fall in demand

If demand were to fall considerably, the government would have to raise the interest it pays, which would prematurely drive up borrowing costs at a time when consumers are still struggling.

The yield on the 10-year Treasury note is closely tied to interest rates on mortgages and other consumer loans.

The US Treasury Department was to issue US$75 billion of debt this week, including US$15 billion in 30-year bonds.

The 10-year auction's bid-to-cover ratio, a measure of demand, was 2.49 percent, down sharply from 3.28 percent at a similar auction in July, but relatively in line with recent levels.

Indirect bids, an indication of foreign buying, were lower than at recent auctions.

The yield at which the notes were offered was slightly higher than the yields of already issued 10-year notes, another sign that demand was weak.

"As a rule of thumb, uncertainty creates higher premiums, so the Treasury had to offer a higher premium to attract buyers," said Chris Bury, managing director and co-head of rates trading and sales at Jefferies and Co.

- AP