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

Oct. 7 (Bloomberg) -- Treasuries fell, snapping the longest rally in a month, after the Federal Reserve said it will buy commercial paper 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 Fed 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 took over Landsbanki Islands hf, its No. 2 lender, and pegged the nation's currency to a trade-weighted index. Most U.S. stocks rose.

``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 climbed 11 basis points, or 0.11 percentage point, to 1.54 percent at 11:04 a.m. in New York, according to BGCantor Market Data. The 2 percent security maturing in September 2010 dropped 7/32, or $2.19 per $1,000 face amount, to 100 29/32. The 10-year note yield increased 7 basis points to 3.53 percent.

The Standard & Poor's 500 Index advanced 0.1 percent.

``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.

Special-Purpose Vehicle

The U.S. central bank 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.

The Fed will purchase asset-backed commercial paper and in cases where the short-term loans are not secured by assets, it will collect fees or other securities.

Rates on commercial paper, or short-term IOUs sold by companies, have soared in recent days as banks lost trust in corporate borrowers. After the Fed's announcement, yields on overnight U.S. commercial paper dropped 74 basis points to 2.94 percent, according to data compiled by Bloomberg. Borrowing for seven days increased 1.25 percentage points to 4 percent.

``When high-quality companies can't float one-week and one- month paper, it's the Fed's job to step in and see what they can do to alleviate the problem,'' said Mark MacQueen, partner and portfolio manager in Austin, Texas, at Sage Advisory Services Ltd., which oversees $6 billion. ``The market needs some liquidity here, and any attempts to increase short-term liquidity are going to be viewed as a positive.''

TED Spread

The TED spread, or the difference between what banks and the U.S. Treasury pay to borrow money for three months, narrowed to 3.51 percentage points today from 3.82 percentage points yesterday.

Over the past four months two-year Treasury notes have risen, pushing yields down almost 1.6 percentage points, as investors have sought the safety of U.S. government debt. The yields touched a high for the year of 3.11 percent on June 13.

The drop in U.S. government debt may temper future price swings in the market. A measure of volatility in the Treasury market reached an all-time high yesterday. Merrill Lynch & Co.'s MOVE index, an options-based gauge of changes in prices for Treasuries, surged to 217.3, the highest since its creation in 1988.

The world economy has already fallen into its first recession since 2001, according to JPMorgan Chase & Co. economists Bruce Kasman and David Hensley.

Inflation Expectations Fall

The weakening economy has brought inflation expectations to the lowest in almost a decade. The difference between rates on 10-year Treasury Inflation Protected Securities, or TIPS, and conventional bonds narrowed to 1.21 percentage points, the lowest since 1999. The spread reflects the outlook among traders for inflation over the next decade.

``You've seen this huge sell-off in TIPS,'' said Tom di Galoma, head of U.S. Treasury trading at Jefferies & Co., a brokerage for institutional investors in New York. ``Inflation expectations are quite low because the economy is getting wrung out.''

The median forecast of 77 economists surveyed by Bloomberg News expects consumer prices to fall to 2.80 percent in 2009, down from 4.50 percent at the end of this year.

To contact the reporters on this story: Dakin Campbell in New York at dcampbell27@bloomberg.net; Bo Nielsen in Copenhagen at bnielsen4@bloomberg.net

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