TREASURIES-Bonds rally on expected Fed buys

* Long bond higher, flattening the yield curve

* 5-year, $10 billion TIPS auction ahead

* Focus is on initial quantitative easing purchases

By Ellen Freilich

NEW YORK, Oct 25 (BestGrowthStock) – 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.

Against the backdrop of expected quantitative easing,
traders set up for the Treasury’s 1 p.m. (1700 GMT) auction of
five-year Treasury Inflation Protected Securities (TIPS).

The yield in the five-year TIPS has been negative since
September as evidence like lower core consumer prices seemed to
increase the likelihood of deflation.

Five-year TIPS traded at – 0.53 percent in midday trade.

The gap between five-year Treasury yields (US5YT=RR: )
and five-year TIPS

Elsewhere, the 30-year bond (US30YT=RR: ) outperformed
shorter maturities, up 30/32 at midday as its yield easing to
3.88 percent from 3.93 late on Friday.

Bargain-hunters bought the 30-year bond which has become
cheaper than other maturities based on the idea that the Fed
would mostly buy shorter-dated securities.

“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.

Bonds traded near record low yields because the market
expects the Fed to enter the market as a major, if not
overwhelming buyer of Treasury debt, traders said.

The Fed’s prospective purchases of U.S. debt, combined with
foreign central banks buying Treasury debt with proceeds from
sales of their own currency, both while sizes of U.S. Treasury
auctions steadily shrink, means a substantial amount of paper
is being withdrawn from the market, supporting prices.

In addition, the deflationary forces that the Fed is
attempting to thwart favor fixed-income securities because
deflation enhances the purchasing power of those investments.

A Goldman Sachs analysis also seemed supportive for bonds.

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 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 about $2 trillion
if the FOMC’s forecasts converge to our own,” it said.

Goldman said if all other policy levers stay where they
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.”

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.

A rise in existing home sales in September was welcome,
analysts said, but TJ Marta, chief market strategist at The
Marta Report in Scotch Plains, New Jersey, noted that the sales
gain was from “extraordinary lows.”

New York Fed Bank President William Dudley said he was
“comfortable” with his Oct. 1 statement that more easing by the
Fed is likely warranted to support the recovery.

He said policymakers “worry about shocks from unanticipated
sources,” adding that the Fed was exploring the foreclosure
issue “to see if that’s a big problem or a smaller problem.”

The benchmark 10-year note (US10YT=RR: ) rose 13/32, its
yield easing to 2.51 percent from 2.56 percent on Friday.
(Editing by Andrew Hay)

TREASURIES-Bonds rally on expected Fed buys