The US Federal Reserve may have to change a self-imposed rule that limits its Treasury debt purchases or expand the scope of its buying along the curve, according to one primary dealer. RBC Capital Markets is betting the central bank will have to expand its 35 percent limit on ownership of individual Treasury issues to accommodate a widely expected second program of quantitative easing, which most on Wall Street predict will be announced after the Federal Open Market Committee's November 2-3 meeting.
"In this situation, the Fed has two options: up the 35 percent limit or not buy as many Treasuries," said Keith Blackwell, US interest rate strategist at RBC Capital Markets in New York. Blackwell expects that by the end of the year the 35-percent rule will begin to distort Treasuries prices, with prices rising in those issues where the Fed has not maxed out its purchases. He says the central bank is likely to announce a broader buying limit at its January meeting, although he says the timing is "highly uncertain."
Investors looking to figure the impact of another Fed round of securities purchases may be well served by considering the ramifications of such an ownership limit expansion. "I think it's a tough thing to call and I think the belly of the curve is going to remain the place to be for the Fed buying," said John Spinello, Treasury bond strategist at Jefferies & Co in New York.
The Fed is widely expected to engage in a program of Treasury debt purchases intended to lower interest rates like those on mortgages and bolster the struggling economy. The central bank's holdings of some Treasury debt issues, including securities maturing in the five-year range - which are expected to be targeted in a new buyback program - have already bumped up against the 35 percent level, according to data from the New York Federal Reserve.
The central bank is currently buying Treasuries using funds from maturing agency bonds and mortgage-backed securities in an effort to keep steady its holdings of domestic securities. It previously bought about $300 billion of longer-term Treasury securities from March through October 2009 as part of its efforts to combat the US recession.
If the Fed doesn't change its ownership limits, it will have to buy Treasuries with longer-dated maturities, as the Fed tends to avoid buying shorter-dated coupons. Either way, further QE is likely to push middle-to-longer dated Treasury yields lower, Blackwell says, although the jury is still out on whether this will help the economy over the longer term.
"The long-run implications for this approach are anything but certain, however, any way you look at it the belly will likely stay rich," he said. "The lion's share of the purchases are going to be concentrated in the belly, from four (year notes) to the 10 (year notes), and within that in fives, sixes and sevens."
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