Fixed Income Recap

Treasuries were mixed today. The short end sold off as the two-year dropped 1/32 of a point in price while the ten-year traded higher by 1/32 of a point. The benchmark curve was steeper on the day by about 3 basis points. A basis point represents .01%.

MBS continue to tighten to Treasuries. Fed buying of agency MBS has definitely had its desired effect as they have tightened more than 60 basis points since the program was implemented at the beginning of the year. February has the potential to be a big month for prepayments as January was slower then expected.

Treasury Inflation Protected Securities (TIPS) were up big today. The on-the-run ten-year TIP was up 1.5% to 104.625, as inflation concerns over monetary easing are making inflation protection look pretty cheap at these levels. Ten-year TIPS were trading in the low 80’s as recently as mid November.

Fed Purchasing
The Fed is about $90 billion into a $500 billion agency MBS buying program aimed at lowering conforming mortgage borrowing costs. Although their explicit guarantee on Fannie and Freddie MBS and senior debt is currently capped at $100 billion for each agency, $200 billion total, they are essentially responsible for all of it at this point. The point is, the Fed is creating liquidity while not taking on any more credit risk on behalf of taxpayers.

Not the same is true however, for what the Fed might begin purchasing in the near future. If this new program is implemented, commercial mortgage-backed securities and small business loans will be bought by the Fed in the open market. Those who support the program claim that the Fed will be getting “more bang for their buck” than if they would go the traditional route and purchased Treasuries. I agree that the effect on credit spreads will be substantial, but supporters of the program appear to be ignoring the added credit risk the Fed will be taking.

The buying and selling of Treasuries through open market operations in order to manipulate the money supply, and therefore interest rates, has long been a primary responsibility of the Federal Reserve. But many argue that with rates being so low, Treasury buying will have little effect.

With the 10 year at 3%, the Fed has a lot of ammo left with regard to lowering rates, even with Fed Funds at .25%. Buying Treasuries, to lower risk free rates, and then allowing the market to price risk without the distraction of government subsidization, is more in line with what the Fed was created to do.

Don’t get this confused with the Treasury’s “Aggregator Bank” idea, where the Treasury would buy risky assets from the balance sheets of troubled financial institutions instead of making more capital injections. In our opinion, the “Aggregator Bank” model under TARP, would be much more effective than the capital injections that were made in late 2008, but differs greatly from Federal Reserve Open Market Operations.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst