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Limited Upside in US Treasuries

In August of this year, the Federal Reserve announced that by the end of October it would begin to gradually phase out of its purchases of US Treasuries. We are now in early December and the initial $300 Billion of allocated capital to purchase Treasuries should be fully deployed. Because of this, one would be led to believe that if all the committed capital by the Federal Reserve was already deployed and that if there has not been a short term spike in Treasury yields, then there must be enough demand to cover the absence of the Federal Reserve in the Treasury market.

But how can there be enough demand for low yielding risk-free assets when we have seen the appetite for risky assets increase, the US Dollar continuing to show weakness, and numerous government officials have been declaring an end to the worst of the economic recession?

There is yet another government action that we must focus on along with the $300 Billion Treasury purchase program. In early 2009, the Federal Reserve committed $1.45 Trillion to purchase Agency and Agency MBS (Mortgage Backed Securities). The initial goal of this program was to help stabilize the credit markets and keep interest rates low to spur the economy. What we believe this program has also done, is provide indirect demand for US Treasuries. It seems as if the Fed purchasing of Agency and Agency MBS has provided cash to counterparties selling the Agency and Agency MBS. The cash being provided for the Agency and Agency MBS is then going on to be used for the purchase of US Treasuries. It is the ongoing effects of this process that are representing the current demand for US Treasuries.

So what happens when the Federal Reserve stops buying Agency and Agency MBS?

The answer will remain to be seen, but in our view the Federal Reserve is nearing the final stage of its purchasing program for Agency and Agency MBS. We think the end of the purchases will be sometime in the first half of 2010, and it will be at that point when we will see the true supply/demand relationship in the US Treasury market.

Disclosure: Long TMV, TBT