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BLBG: Treasuries Tumble as Fed Agrees to Purchase Commercial Paper
By Dakin Campbell and Bo Nielsen

Oct. 7 (Bloomberg) -- Treasuries declined after the Federal Reserve said it will purchase commercial paper through a special unit in an effort to thaw short-term lending markets, damping demand for the haven of government debt.

Two-year notes fell for the first time in five days, pushing yields up from the lowest level since March, after the central bank invoked emergency powers to support the financing needs of corporations. The U.K. may invest as much as $79 billion in the country's three largest banks, while Iceland today took over Landsbanki Islands hf, the island nation's No. 2 lender, and pegged its currency to a trade-weighted index.

``This relieves some of the pressure,'' said Brian Edmonds, head of interest rates at Cantor Fitzgerald LP in New York, one of 17 primary dealers that trade with the Fed. ``This is a major step in freeing up capital, at least to flow through to corporates, and right now the market is perceiving that as an important step.''

The yield on the two-year note rose 13 basis points to 1.57 percent at 9:32 a.m. in New York, according to BGCantor Market Data. The 2 percent security maturing in September 2010 dropped 8/32, or $2.50 per $1,000 face amount, to 100 27/32.

The Fed will lend against a special purpose vehicle at the targeted federal funds rate. The unit will purchase from eligible issuers three-month dollar-denominated commercial paper at a spread over the three-month overnight-indexed swap rate, according to a statement in Washington today.

Australian Rates

Demand for the safest assets ebbed after Australia's central bank cut interest rates by the most since 1992, spurring speculation more banks may follow suit to head off a global recession.

``We've had a big rally over the last couple of weeks in Treasuries, so people are taking some of that money off the table,'' said Wilson Chin, a fixed-income strategist in Amsterdam at ING. ``But it's still too early to call the end of the flight to safety.''

The drop in U.S. government debt snapped the longest rally in a month as investors sought a haven amid weakness in credit markets and European bank rescues.

``Treasuries are under a bit more pressure because of the renewed risk appetite,'' said Orlando Green, a fixed-income strategist in London at Calyon, a unit of Credit Agricole SA. ``But it's a fragile move.''

Credit Crisis

News of plans to shore up British banks followed the agreement yesterday by Germany and financial institutions on a rescue package for Hypo Real Estate Holding AG and BNP Paribas SA's decision to join a state-backed bailout of Fortis, Belgium's largest financial-services company.

``There's a lot of focus on the credit crisis in Europe at the moment,'' said Mik Ingenuus Joergensen, head of research in Copenhagen at Nordea Markets, part of the biggest Scandinavian Bank.

The U.K. government has already bailed out Bradford & Bingley Plc and brokered the takeover of HBOS Plc in the past month on concern about the banks' ability to fund themselves. Chancellor of the Exchequer Alistair Darling said yesterday he will do ``whatever it takes'' to keep the financial system stable as capital markets remain frozen.

Iceland's Financial Supervisory Authority took control of Landsbanki because there is ``a risk of default,'' Chamber of Commerce spokesman Finnur Oddson said in an interview today.

Banks have been hoarding cash on concern that credit- related losses are spreading. The TED spread, or the difference between what banks and the U.S. Treasury pay to borrow money for three months, dropped to 3.56 percentage points today, after earlier widening to 3.91 percentage points, from 3.82 percentage points yesterday. It was 1.12 percent a month ago.

The cost of borrowing in dollars overnight jumped more than a percentage point, the British Bankers' Association said today. The London interbank offered rate, or Libor, that banks charge each other for such loans climbed 157 basis points to 3.94 percent, BBA data showed today.

To contact the reporter on this story: Bo Nielsen in Copenhagen at bnielsen4@bloomberg.net