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INSIDE DEBT

PRODUCED BY REUTERS IN PARTNERSHIP WITH ICAP Wednesday, October 27, 2010

CHART OF THE DAY MARKETS TODAY


U.S. durable goods: new orders TODAY’S TOP STORY: Demand for a range of long-lasting U.S. manu-
factured goods unexpectedly fell last month and a gauge of business
spending plans also dropped, underscoring the economic recovery's tepid
pace. For more please click here

TREASURIES: U.S. government debt prices fell as traders reduced


bullish bets on the Federal Reserve's next bout of bond purchases and
the five-year debt sale fetched lukewarm demand.
The government sold $35 bln in 5-yr notes auction at a yield of 1.330
pct.
10-yr notes were down 22/32 to yield 2.72 pct from 2.65 pct.
30-yr bonds fell almost a point yielding 4.06 pct. while 2-yr notes were
down 1/32 to yield 0.41 pct.
2-10's part of the yield curve steepened by 6 bps to 231 bps while 10-
30's flattened by about 2 bps to 133 bps.
New orders for durable goods increased 3.3 percent
in September, due to a 105 percent surge in non-
FOREX: The dollar's rise pushed it into positive territory against major
defense aircraft/aircraft parts. Excluding transporta-
currencies for the year as investors continued to unwind bets against the
tion, new orders fell 0.8 percent.
greenback before a highly anticipated Federal Reserve meeting.
The dollar index rose 0.52 pct to 78.109.
TODAY’S TOP NEWS Dollar was up 0.34 pct at 81.68 yen, after rising to a 2-wk high of 82
Mixed U.S. data confirm slow economic growth path yen.
Euro fell 0.69 pct to $1.3763. The euro fell as low as $1.3758.
Fed seen buying few hundred bln dlrs Treasuries- The Australian dollar fell 1.47 pct to $0.9723.
WSJ The euro fell 0.33 pct to 112.43 yen.
U.S. Treasury - foreclosure woes not systemic
threat
CORPORATES: U.S. corporate credit spreads weakened as fears the
Federal Reserve would buy fewer assets than previously expected
U.S. Fed won't join banks in appeal to Supreme sparked renewed risk aversion.
Court The CDX.IG-15 index widened by 1 bps to 94 bps.
CFTC should be flexible on limits-Morgan Stanley Momentive Performance Materials sold $635 mln of springing second
lien notes. Travelers launched a $1.25 bln two-part debt sale and Geor-
ECB's Stark talks up recovery gia-Pacific launched a $1.25 bln 10-yr note sale.
U.S. home loan demand up as rates near record
STOCKS: The Dow industrials and the S&P 500 fell as investors reined
lows in expectations of how aggressive the U.S. Federal Reserve may be in its
efforts to stimulate the economy.
ECON WATCH Dow lost 0.39 pct to 11,125.60, S&P was down 0.27 pct to 1,182.44 and
FOR THURSDAY OCTOBER 28 Nasdaq gained 0.24 pct to 2,503.26.
The VIX index rose 2.42 pct, S&P Materials index lost 0.85 pct and S&P
ET Indicators Unit Reuters Prior
Energy index fell 0.60 pct.
02:00 GB Nationwide house prc mm % -0.4 0.1
Freeport McMoRan Copper & Gold slumped 2.83 pct. Pioneer Natural
02:00 GB Nationwide house prc yy % 2.3 3.1 Resources dipped 2.92 pct. P&G edged up 0.35 pct. Transportadora de
04:00 DE Unemploymt change k -30 -40 Gas Del Sur soared 9.57 pct to $4.35, while IRSA Investments and
04:00 DE Unemployment total nsa mln 2.93 3.031 Representations jumped 7.61 pct to $14.98.
04:00 DE Unemployment rate sa % 7.4 7.5
05:00 EZ Business climate ind 0.79 0.77 C & E: Oil prices slid nearly 1 percent, pressured by a rally in the dollar
05:00 EZ Economic sentiment ind 103.2 103.2
as doubts percolated among investors about the size of a much bally-
hooed U.S. economic stimulus move by the Federal Reserve.
05:00 EZ Industrial sentiment ind -1 -2
U.S. oil slid 0.71 pct at $81.96 per barrel.
05:00 EZ Services sentiment ind 8 8
Gold was down 1.01 pct to $1,325.19 an ounce.
05:00 EZ Consumer sentiment ind -11 -11
Reuters-Jefferies index shed 0.71 pct to 299.14.
08:30 US Initial Claims k 453 452
08:30 US jobless contin claims mln 4.40 4.441
 For MARKET SNAPSHOT click here
19:50 JP Industrial output prelim % -0.6 -0.3
JP BoJ holds 1-day Monetary Policy Meeting  For NEXT UP click here
GR National Holiday  For DEEP DIVE click here
INSIDE DEBT October 27, 2010

MARKET SNAPSHOT as of 3:00 pm EST

TREASURIES <5> <500> EQUITIES


BID ASK YIELD CHANGE INDEX CHANGE
1-Mo Bill 0.150 0.115 0.152 0.008 DJIA 11085.11 -84.35
3-Mo Bill 0.135 0.125 0.137 0.003 NASDAQ 2494.82 -2.45
6-Mo Bill 0.175 0.165 0.178 0.002 S&P 500 1178.48 -7.16
1-Year 0.225 0.210 0.229 0.001
2-Year 99.914 99.945 0.419 -0.016 OIL
3-Year 99.633 99.672 0.626 -0.078 PRICE CHANGE
5-Year 99.727 99.773 1.308 -0.242 NYMEX 82.0 -0.6
7-Year 99.016 99.063 2.028 -0.398 BRENT 81.8 0.7
10-Year 99.234 99.297 2.714 -0.594
EURODOLLAR FUTURES
30-Year 97.063 97.125 4.045 -0.781
CLOSE CHANGE
Nov-10 99.70 0.00
IR SWAPS <19901> Dec-10 99.66 -0.01
SPREAD RATE Mar-11 99.60 -0.01
REPURCHASE AGREEMENTS 2-Year 14.50 18.50 0.56 0.59 Jun-11 99.54 -0.01
G/C MORTGAGE REPOS 3-Year 20.25 24.25 0.82 0.85
O/N 0.270 O/N 0.290 5-Year 23.75 27.75 1.54 1.56 FUTURES
2-Week 0.280 2-Week 0.290 7-Year 15.25 19.25 2.18 2.19 PRICE CHANGE
1-Month 0.280 1-Month 0.300 10-Year 6.75 10.75 2.78 2.78 CBOT 5 yr 121.65 -0.23
3-Month 0.290 3-Month 0.320 30-Year -37.25 -33.25 3.67 3.66 CBOT 10 yr 126.77 -0.27
AGENCY REPOS i-REPOSM INDEX CBOT 30 yr 132.09 -0.34
O/N 0.260 10:00 AM 0.200 CURRENCIES
U.S. Interest rate swap—yield curve
2-Week 0.280 3:00 PM 0.199 BID ASK
1-Month 0.290 Euro 1.3759 1.3762
3-Month 0.300 Sterling 1.5755 1.5758
JP Yen 81.72 81.74
EURODOLLAR DEPOSITS & OIS STRIPS Swiss Franc 0.9912 0.9914
(ASKED)
Can Dollar 1.0291 1.0298
BID ASK BID ASK Mexico 12.4644 12.4684
O/N 0.200 0.230 - -
1-Month 0.250 0.330 0.185 0.195 FED FUNDS NYFRSM - 10AM
3-Month 0.290 0.400 0.177 0.187 Open 0.2100 1m 0.2512
6-Month 0.450 0.600 0.173 0.183 High 0.2300 3m 0.3013
12-Month 0.760 1.000 0.190 0.200 Low 0.1800

ACTIVE FANNIE MAE AGENCIES ACTIVE FREDDIE MAC AGENCIES


TERM COUPN MATURITY YIELD-SPREAD YIELD TERM COUPN MATURITY YIELD-SPREAD YIELD
2-Year 0.375 30/11/2012 8 6 0.49 2-Year 0.5 30/10/2012 7 - 0.48
3-Year 1 23/09/2013 12.5 12 0.74 3-Year 0.875 28/10/2013 12.5 12 0.74
5-Year 1.625 26/10/2015 27 26 1.57 5-Year 1.75 10/09/2015 22 20 1.52
7-Year - - - - - 7-Year - - - - -
10-Year - - - - - 10-Year 3.75 27/03/2019 -5.5 -6.5 2.66
30-Year 6.625 15/11/2030 12 7 4.16 30-Year 6.25 15/07/2032 12 9.75 4.16

Active MBS 15YR Wrightson ICAPSM Chart of the Day


CPN BID ASK YIELD
FNMA 4.0 104.1260 104.1320 2.352
FHLMC 4.0 104.1070 104.1130 2.345

Active MBS 30YR


CPN BID ASK YIELD
FNMA 4.5 104.2100 104.2100 2.268
FHLMC 4.5 104.1200 104.1200 2.426
GNMA 4.5 105.2500 105.2500 2.775

2
INSIDE DEBT October 27, 2010

TODAY’S TOP NEWS


Mixed U.S. data confirm slow economic growth path Fed seen buying few hundred bln dlrs Treasuries-WSJ

Demand for a range of long-lasting U.S. manufactured goods The U.S. Federal Reserve is likely next week to unveil a pro-
unexpectedly fell last month and a gauge of business spending gram of U.S. Treasury bond purchases worth a few hundred
plans also dropped, underscoring the economic recovery's tepid billion dollars over several months, the Wall Street Journal re-
pace. ported.
Orders for durable goods excluding transportation fell 0.8 per- What the Journal report called a "measured approach" com-
cent after rising 1.9 percent in August as bookings for communi- pares with investors' base-case scenario of an initial commit-
cations equipment tumbled sharply. ment to buy at least $500 billion in Treasury debt over five
Overall orders, however, jumped by 3.3 percent -- the largest months, in an effort to spur lending and to support an economic
increase since January -- lifted by a surge in demand for aircraft. recovery that is too weak to tame high unemployment.
The second report showed new home sales rose 6.6 percent The Journal said Fed officials wanted to avoid the "shock and
last month to a still-weak 307,000 unit annual rate. awe" style used during the global financial crisis in favor of an
Non-defense capital goods orders excluding aircraft slipped 0.6 approach that allowed them to adjust their policy, and possibly
percent in September after a 4.8 percent increase in August. add to their purchases, over time as the recovery unfolded.
Inventories of durable goods inventories rose for a ninth straight It said the Fed could leave open the possibility of more pur-
month, while shipments, which go into the calculation of gross chases in the future or it could halt the program if the economy
domestic product, were down for the second consecutive month. or inflation took off surprisingly. The bond-buying program is
The number of new homes available for sale last month dropped likely to focus on Treasury bonds with maturities mostly be-
to a 42-year low of 204,000, the Commerce Department's report tween two years and 10 years, it said. The Fed could buy even
showed. At September's sales pace, that represents an eight longer-term bonds, although some officials are reluctant to do
months supply, down from 8.6 months' worth in August. that aggressively because it could expose them to long-term
The median sales price for a new home rose 1.5 percent from losses without much added benefit, it said.
August to $223,800, the highest since May.
U.S. Fed won't join banks in appeal to Supreme Court
U.S. Treasury - foreclosure woes not systemic threat
The Federal Reserve has decided not to join major banks in
The U.S. Treasury does not see a risk that banks may have to asking the U.S. Supreme Court to let the central bank keep se-
take back mortgage securities because of faulty foreclosure cret the details of its emergency lending programs during the
documents as a systemic threat to the financial system, a senior financial crisis.
Treasury official said. A group representing U.S. and European commercial banks on
Meanwhile, the U.S. Treasury's housing rescue boss said that Tuesday appealed to the Supreme Court asking it not to force
reviews and investigations into the use of faulty foreclosure the Fed to disclose details of its bailouts, as a federal appeals
documents will likely delay the sale of thousands of distressed court in New York had ordered in March. The group said forc-
properties, exerting downward pressure on home prices. It may ing disclosure could lead markets and customers to worry about
take several months for mortgage servicers, state courts and banks' health, jeopardizing their business prospects.
law enforcement agencies to clear up questions over foreclo- The Fed did not explain why it chose not to join the banks' ap-
sures, Phyllis Caldwell, chief of the Treasury's Homeownership peal. In a statement, it said it "will await a determination from
Preservation Office, told the Congressional Oversight Panel. the courts and will comply fully with any final order. The Fed
Longer foreclosure timelines will push down prices, particularly remains committed to timely and responsible transparency of its
for vacant houses, and uncertainty over the status and titles of operations."
already foreclosed homes may also discourage buyers. The Clearing House said disclosure may harm banks "by allow-
Separately, banks must adequately assess risks associated with ing the public to observe their borrowing patterns during the
potentially having to take back mortgage securities due to faulty recent financial crisis and draw inferences about their current
foreclosure documentation, a top U.S. bank regulator said. financial conditions."

CFTC should be flexible on limits-Morgan Stanley ECB's Stark talks up recovery

Morgan Stanley urged the U.S. CFTC to adopt a flexible ap- ECB policymaker Juergen Stark talked up improvements in the
proach toward speculative position limits, a new regime that the euro zone's economy and lending markets, as the bank re-
regulator is slated to unveil in coming weeks. started the slow process of removing its crisis support.
The banking firm recommended the CFTC propose interim limits French consumption rose three times faster than expected last
in energy markets, and possibly certain precious metals markets month. Germany's headline unadjusted jobless total also fell in
that would not prevent businesses from using futures and swaps October to its lowest since October 1992.
to hedge risk. Stark stuck to the ECB's recent assessment that the euro
"The levels should be high enough to allow a margin for the zone's economic recovery would continue at a moderate pace
possibility that the commission has insufficient data to determine and that there was currently neither a risk of overly strong infla-
the true size of the market for which it establishes the limit," said tion or deflation. Reuters data also show overnight bank-to-bank
Simon Greenshields, managing director and co-head of the trading volumes have almost trebled since June.
global commodities division, in a letter to the regulator. The ECB held its first 'indexed' three-month refinancing opera-
The firm said it agreed with recommendations from the Futures tion, a baby step in its efforts to wean banks off the emergency
Industry Association, which also urged a flexible approach. support it has given since the financial crisis worsened in 2008.
The rule should include exemptions from the limits for hedgers Banks borrowed 42.5 billion euros, 10 billion more than traders
and risk managers, Morgan Stanley said, and should not pre- were predicting in the run up to the operation but the high de-
vent hedgers and risk managers from also holding speculative mand was put down to price of the funds rather than any re-
positions below the limit. newed market tensions.

3
INSIDE DEBT October 27, 2010

TODAY’S TOP NEWS


U.S. home loan demand up as rates near record lows German data point to subdued euro zone inflation

U.S. mortgage applications for home purchasing and refinancing Annual inflation held steady in Germany at 1.3 percent in Octo-
rose last week as consumers sought to take advantage of near- ber, data showed, offering an early indication that price pres-
record low interest rates, data from an industry group showed. sures in the euro zone as a whole remain in check for now.
While the uptick bodes well for the housing market demand has The CPI rose by 1.3 percent on the year, unchanged from Sep-
been tepid, reflecting the inability of many consumers to take tember, according to data from the Federal Statistics Office that
advantage of rock-bottom rates. matched a forecast from a Reuters poll of 36 economists.
The MBA said its seasonally adjusted index of mortgage appli- Annual inflation was 1.8 percent in September and is expected
cations increased 3.2 percent for the week ended Oct. 22. The to show the same reading for October, according to a Reuters
four-week moving average was up 1.4 percent. It was only the poll. The Statistics Office said inflation was, as in previous
second time in eight weeks activity rose. months, driven mainly by price rises in light heating oil and fuels
The MBA's seasonally adjusted index of refinancing applications as well as in fruit and vegetables.
increased 3.0 percent. Borrowing costs on 30-year fixed-rate Euro zone M3 money supply was also subdued, rising 1.0 per-
mortgages, excluding fees, averaged 4.25 percent. Interest cent on an annual basis in September, ECB data showed ear-
rates were also below their year-ago level of 5.04 percent. lier. Forecasts had been for a 1.3 percent rise.
By lowering monthly mortgage payments, lower rates may also At 0.8 percent, the three-month moving average of M3 growth
help some homeowners avoid default and foreclosure if their remained well below the ECB's reference rate of 4.5 percent,
credit is good enough. The MBA said fixed 15-year mortgage above which the bank sees dangers to medium-term price sta-
rates averaged 3.67 percent, down from 3.74 percent the previ- bility.
ous week.
BoE's Posen - UK recovery is not inflationary
China warns of inflationary pressure, vows action
Britain's fledgling economic recovery is not fuelling a surge in
China's central bank said that inflationary pressures should not inflation, Bank of England policymaker Adam Posen said in a
be overlooked, while the cabinet vowed to stabilize consumer newspaper interview published. Posen also said the financial
prices and curb overly rapid increases in property prices. sector was not "fixed yet".
Taken together, the statements signaled heightened concern Meanwhile, judging the level of spare capacity in the economy
over price and asset bubble risks, despite an assurance from is particularly difficult at the moment, although surveys suggest
China's top planning agency that near-term inflation would re- it is relatively modest, BoE Deputy Governor Charles Bean said.
main under control. Bean noted that different statistical approaches threw up very
Consumer price inflation hit a 23-month high of 3.6 percent in different outcomes.
the year to September and most analysts expect it to rise a little An assumption that Britain's economy was operating around
further. The State Council said after a meeting to discuss eco- potential leading up to the crisis and potential output had contin-
nomic plans for the fourth quarter that stabilizing prices of vege- ued to rise would mean output is now running almost 10 percent
tables and daily necessities would be high on the government's below potential. But indicators of capacity utilization drawn from
agenda and also vowed to tame rampant property prices. business surveys and the limited rise in unemployment sug-
The government has curbed lending to developers, raised mort- gested a "very different picture". An assessment of spare ca-
gage rates and enforced higher down payments as part of a pacity is crucial to determining how fast an economy can grow
series of measures to cool the red-hot property sector. without generating inflationary pressures.

NEXT UP
Oil price forecasts rise on U.S. monetary easing Uneven recovery means ECB rates on hold until Q4 2011

Oil will average over $83 a barrel in 2011, a Reuters poll The euro zone's uneven economic recovery will force the Euro-
showed, as expectation that a new round of U.S. monetary pean Central Bank to keep interest rates on hold until the fourth
stimulus would shore up the economy led analysts to raise fore- quarter of next year while it supports weaker members, a
casts for the first time in six months. Reuters poll of 80 economists showed.
Some analysts, however, said the upward revision was fragile They also said Bundesbank President Axel Weber remains the
as the amount and delivery method of U.S. monetary easing most likely choice to succeed Jean-Claude Trichet as ECB
could still surprise on the downside and, combined with weak oil president next year. But Weber's sharp public critique two
demand growth, could still put oil prices under pressure. weeks ago of the effectiveness of the bank's bond purchase
U.S. crude oil prices were expected to average $83.32 a barrel program appears to have dented his chances.
in 2011, according to a Reuters poll of analyst price forecasts, The median of the poll forecasts showed interest rates on hold
up from $83.00 a barrel forecast in September. at a record low 1.0 percent until the fourth quarter of next year,
More than a quarter of the 33 analysts, banks and government when they are expected to rise to 1.25 percent.
agencies polled increased their 2011 consensus forecasts from They also expected the ECB to hike rates by 25 basis points in
last month, reversing five months of downward revisions. both the first and second quarters of 2012., unchanged from the
Data compiled by Reuters shows that the negative correlation last poll, and saw no chance of a rate hike resulting from the
between crude prices and the greenback intensified over the ECB's November meeting. Respondents gave a median 25 per-
past month. cent chance of a rate hike by mid-2011. Thirty-three out of the
In the poll, Goldman Sachs had the most bullish forecast for 50 economists who answered an extra question about who
U.S. crude at $98.50 next year, although the heavyweight bank would be the next ECB president tipped Axel Weber as the
revised the level down from $100 in the last month poll. most likely candidate to replace Jean-Claude Trichet.

4
INSIDE DEBT October 27, 2010

DEEP DIVE Commentary and Analysis


Massive QE would forcibly alter investor portfolios

By John Kemp
As the Federal Reserve considers a new round of quantitative
easing (QE2) it is worth asking what purchases on the initially
forecast scale would do to the market for the U.S. Treasury se-
curities and the distribution of investor portfolios.
St Louis Fed Research Director Christopher Waller recently
indicated the program might begin with a target of buying $500
billion with further increments of $250 billion.
The St Louis Fed has been at the forefront of the campaign for
more QE to avert the peril of deflation, so Waller's views may
not reflect the overall balance of opinion within the central bank.
Other officials are more skeptical.
A Wall Street Journal report suggests the Fed is preparing to
announce an initial "more measured" program of only "a few
hundred billion".
Until now, many observers were anticipating the central bank
will eventually purchase between $500 billion and $1 trillion of
mostly or exclusively U.S. Treasury securities. Debt already owned by the Fed and foreign governments is
Purchases on this scale would effectively drive private investors mostly short-term. Nonetheless, once the total is adjusted to
out of the medium-term government bond market and forcibly exclude official holdings, the proportion of marketable debt in
alter the composition of their portfolios on an unprecedented the 2014-2020 window owned by the Fed after QE2 will likely be
scale. a few percentage points higher, at 20-40 percent.
Fear of the consequences is one reason the Fed may pull back
and announce a smaller program. BORROWING PROFILE
The total amount of government debt in issue is rising as a re-
U.S. DEBT PROFILE sult of the budget deficit. In the 12 months ending September
At the end of September, the United States owed $13.561 tril- (fiscal 2010) the federal government ran a budget deficit of
lion, according to the Monthly Statement of the Public Debt, $1.294 trillion, according to the Financial Management Service
issued by the U.S. Treasury. But the amount of government (FMS). The government issued more than $5 trillion of new debt
debt securities actually held by private investors and institutions instruments to cover this borrowing requirement and roll over
such as pension funds was far smaller. expiring securities.
Of the total, some $4.539 trillion (33 percent) was owed to other The overwhelming proportion of new securities was issued at
parts of the U.S. government (such as the Social Security and maturities of three years or less. Only $1.183 trillion were me-
Medicare trust funds) and represents an accounting transfer. dium-term securities expiring between 2014 and 2020 (Chart 2).
Another $547 billion was issued in "non-marketable" forms such
as savings certificates of special debt instruments held by state
and local governments.
The amount of "marketable" debt held by the public was just
$8.475 trillion. But even this substantially overstates the open
market in government debt.
The Federal Reserve has already bought $824 billion of U.S.
Treasuries, according to the central bank's weekly condition
statement (H.4.1). Federal Reserve Banks also hold another
$2.547 trillion of marketable U.S. Treasury securities on behalf
of foreign governments such as China and institutions such as
the IMF.
The amount of marketable U.S. debt held by private individuals
and institutions is just $5.104 trillion. Purchases on a scale of
$500 billion to $1 trillion would reduce that by 10-20 percent.
This still understates the impact on the market, because many
medium and long-term notes are tightly held by institutional in-
vestors such as pension funds to match their liabilities and are
not freely available (though they may be loaned to dealers). The The Fed is unlikely to purchase securities direct from the Treas-
impact on the debt market would therefore be enormous. ury at the regular public auctions. But if it buys $500 billion to $1
Most dealers expect the Fed to concentrate its purchases on trillion of securities in the secondary market in the 2014-2020
securities with a maturity of between 5 and 10 years (maturing window, it would be monetizing 42 and 84 percent of debt issu-
between 2014 and 2020) in a bid to hold down yields in this part ance in this segment. The Fed would essentially be covering all
of the curve. the government's medium-term borrowing requirement.
Of the $8.475 trillion of marketable securities held by the public, To keep the medium-term market liquid, the Treasury could
more than half ($4.712 trillion) matures before the end of 2013. alter the composition of security sales, issuing fewer short-term
Only a third matures between 2014 and 2020 ($2.922 trillion). securities and more medium-term notes. But that would leave
Purchases on the initially expected scale would lead to the Fed the Fed open to accusations it was monetizing debt no private
owning 17-34 percent of the available debt at these maturities investor would be prepared to buy. So the broad composition of
(Chart 1). issuance may change only at the margin, making the Fed the

5
INSIDE DEBT October 27, 2010

DEEP DIVE Commentary and Analysis


dominant player in the medium-term government debt market. oil market in the 1990s. Fed holdings will exceed available li-
quidity. There will be no way to unwind the position without in-
FORCIBLE ADJUSTMENT curring big losses, unless the government embarks on a huge
China and other foreign holders of Treasury securities could fiscal consolidation program in the medium term.
exploit QE to exit from their own over-large positions in the (2) The Fed risks creating a false market in medium-term Treas-
Treasury market. But this would be regarded as an unfriendly uries and other instruments, as well as a big distortion in inves-
act, frustrating the purpose of the program, and would be tor portfolios. By removing Treasuries from circulation and buy-
strongly discouraged. ing them back from existing holders regardless of price, the Fed
The Fed hopes the majority of the securities it buys will come will forcibly over-ride investors' portfolio preferences. When the
from private institutions' existing holdings and new government program is stopped, or unwound, normal preferences will reas-
emissions that would otherwise have been bought by them. In sert themselves, risking a snap back in medium-term Treasury
effect, the Fed would be forcibly removing $500 billion to $1 yields and a disruptive reallocation of portfolios.
trillion in government securities from private portfolios and leav- The program's architects hope to over-ride preferences only
ing individuals and institutions with no choice but to invest in during that part of the cycle when demand for liquidity is abnor-
something else. mally and harmfully high, letting market forces reassert them-
It is possible the funds will be reinvested in short-term T-bills or selves when demand for liquidity has normalized and demand
held as a further increase in excess reserves with the Federal for higher-risk assets has recovered. But sequencing and fine-
Reserve Banks. But the Fed hopes to saturate (i.e. overwhelm) tuning policy to this extent is notoriously hard.
demand for these highly-liquid assets and force investors to buy If the government cannot bring down its borrowing and the Fed-
mortgage-backed bonds, corporate bonds, equities and other eral Reserve cannot time an exit strategy precisely right, reduc-
financial instruments instead. Ultimately, it wants investors and ing and unwinding QE2 will roil the markets further.
corporations saturated with cash and liquid instruments to invest Fear about the distortions created by a more massive program
in less liquid physical assets such as buildings and equipment. may be one reason leading Fed officials are now signaling more
But there are some major side effects to the program: modest purchases of only a few hundred billion, which risks
(1) The Fed's dominant position will likely trap the central bank. disappointing markets that were expecting much more.
It will have the same problem as China's State Administration of
Foreign Exchange (SAFE) in Treasury bonds during the 2000s -- John Kemp is a Reuters market analyst. The views ex-
and Metallgesselschaft Refining and Marketing (MGRM) in the pressed are his own --

INSIDE DEBT is produced by Reuters in partnership with ICAP.

(Compiled by Pronita Naidu and Mowna Ravikumar in Bangalore)


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