Investors Take Big Leap

Yesterday's big Treasury rally, which brought the U.S. 10-year down 19 basis points to 2.73%, a 43-year low, was spurred by a number of factors, including yesterday's weak ISM index and continued weakness in global equities prices. A major influence over the past week reinforced yesterday by Federal Reserve Chairman Ben Bernanke is the Federal Reserve's announcement that it will purchase agency and agency mortgage-backed securities, up to $100 billion and $500 billion, respectively. The announcement encouraged investors to move one layer out the risk spectrum, moving into the mortgage realm, an area critical to the recovery of the financial markets and the economy.

The Fed's announcement was a de facto initiation of a strategy designed to target long-term interest rates, a strategy that Bernanke mentioned in his now-famous November 2002 speech on deflation ("Making Sure 'It' Doesn't Happen Here") and again on Monday in this important passage:

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver -- the provision of liquidity -- remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand.

Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.

The importance of the improvements in the mortgage realm should not be underestimated given the destruction that the mortgage realm has caused.

Moreover, it is immensely important that the Fed sparked movement further out the risk spectrum. Progress began first in the money market -- in LIBOR and the commercial paper market -- and has now moved to agency and mortgage-backed securities. The next step is high-grade corporate debt. Investors won't move there until they have a better bead on the depth and duration of the recession.

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Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of the revised investment classic, The Money Market, first published in 1978 by Marcia Stigum, and The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback; click here to send him an email.

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