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US Treasury prices reversed early losses on Monday and rallied on mortgage-related buying of longer-dated Treasuries after the government took control of embattled mortgage giants Fannie Mae and Freddie Mac.
Early in the day Treasuries posted losses as the safety bid for safe-haven US government debt unravelled on news of the Treasury's rescue of Fannie and Freddie, potentially one of the bigget US government bailouts ever. But demand for Treasuries re-emerged when mortgage-related accounts bought Treasuries to adjust average portfolio durations that had contracted as yields on mortgage securities narrowed in relation to Treasuries.
"Mortgageicers were short duration so they had to buy 10-year Treasuries to lengthen the average duration of their portfolios," said Andrew Brenner of MF Global Inc.
Benchmark 10-year Treasury notes began the session in the minus column, but by late afternoon were up 12/32, their yields easing to 3.66 percent from 3.71 percent late on Friday. Two-year notes rose 1/32, their yields easing to 2.30 percent from 2.32 percent on Friday. Investors often scramble for longer-dated Treasuries and interest rate swaps to stabilise their mortgage portfolios if they anticipate an acceleration in mortgage prepayments. Faster prepayments erode the value of mortgage investments because investors lose the interest income they are counting on. The yield spread on 10-year interest swap contracts over comparable Treasuries on Monday shrank to a level not seen since late May.
"Mortgages dramatically outperforming Treasuries caused a bit of flight into the long end," said William O'Donnell, head of US interest rate strategy and research with UBS in Stamford, Connecticut. Chris Rupkey, vice president and chief financial economist at Bank of Tokyo/Mitsubishi, said volatility in 10-year Treasury yields was tremendous.
"People are squaring up positions here and trying to stay out of trouble," he said. "Mortgage bond yields are coming in dramatically relative to Treasuries and that should contribute to the stability of the mortgage market and will translate into reduced cost of mortgages for consumers."
Lehman announced plans on Monday to report third-quarter results on September 18 and to update investors on "strategic initiatives." "The Treasury market started to get a bid right at the time that Lehman made that announcement," said Rupkey. "People are skeptical." Lehman shares fell 12.65 percent to $14.15 on the New York Stock Exchange.
Relief over the Treasury's move to bail out Fannie and Freddie helped push US stocks, especially banking stocks, higher. Five-year Treasury notes rose 2/32 in price, their yields easing to 2.98 percent from 2.99 percent late on Friday, while the 30-year bond climbed 25/32, its yield easing to 4.27 percent from 4.31 percent.

Copyright Reuters, 2008

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