February 13, 2009 / 6:27 PM / in 10 years

Fed must buy Treasuries soon to lower rates: Connolly

NEW YORK (Reuters) - The Fed should buy $2.5 trillion of U.S. Treasury securities now to fix the financial system and avoid having to nationalize banks, said Bernard Connolly, an economist who a year ago correctly forecast that the U.S. government would buy equities.

As the global credit crisis intensified, the U.S. government took stakes in several major banks in October to avert a systemic collapse of the financial system. But Connolly, managing director of Connolly Global Macro Advisors in London, says more must be done.

“The Fed could help by trying to support asset values. I think that’s absolutely crucial,” Connolly told Reuters in an interview this week. “What it should be doing is engaging in massive purchases of Treasuries. They have to do it quickly.”

Hefty Treasury purchases would trim yields and reduce borrowing costs, easing the pain for homeowners and companies.

Without that, Connolly said, a $789 billion stimulus package expected to be passed by Congress on Friday won’t be enough to keep the economy from spiraling into a deeper recession, and perhaps depression.

Federal Reserve Chairman Ben Bernanke signaled at the start of December that the central bank was considering buying longer maturity Treasuries. But government bond investors have since grown impatient at the Fed’s inaction.

In a speech this week, Bernanke omitted to mention the possibility of Treasury purchases, putting bond prices under more pressure. A surge of government issuance also helped boost the 10-year yield to 3 percent this week from a five-decade low of 2.04 percent on December 18.

Analysts expect the government to issue $2 trillion of debt this year, on top of the nearly $6 trillion outstanding. If the Fed bought $2.5 trillion of Treasuries, the central bank would control nearly one-third of the market.

Such heavy intervention would raise the risk that should bond yields ultimately spike higher, the Fed could “take it on the chin,” with losses in its portfolio, Connolly warned.

NATIONALIZATION THREAT

He says the Fed needs to push the benchmark 10-year note’s yield down to between 1.5 percent and 2 percent to help stabilize the financial system and economy.

A role model is the Bank of Japan, whose balance sheet grew to about one-third of Japanese gross domestic product in the 1990s as it pulled government bond yields down.

Some investors have worried that excessively low U.S. Treasury yields constitute a “bond market bubble.” But Connolly says this misses the bigger point: the financial system might implode if the Fed sits on its hands.

If that happens, “we may end up with nationalization of banks,” he said. “It’s not something I like by any means and I think it’s something that’s worth avoiding if possible,” he said.

U.S. Treasury Secretary Timothy Geithner this week called for a public-private fund to buy troubled assets of up to $1 trillion to get banks lending again.

The plan did not elicit enthusiasm on Wall Street, partly because investors were betting Geithner would instead endorse a government-run “bad bank” to buy private firms’ toxic assets.

Connolly said the latter was preferable because it would force policy-makers to take a lead role in fighting a crisis they helped create by keeping interest rates low and credit conditions excessively lax over the past decade.

“My preference,” he said, “would be a bad bank which buys assets at or above current marks. Why? Because in a sense it’s the fault of the authorities that the bubble developed in the first place.”

TICKING CLOCK

The longer governments delay in taking steps to fix the credit crisis and the global downturn, the greater the danger that huge sovereign debt issuance sparks runaway inflation, Connolly said.

That scenario, especially if combined with deepening distrust among lenders and borrowers, could allow gold to rise as high as $2,000 an ounce, said Connolly, who professes to have been a gold bull since 1998. Spot gold traded at $938 an ounce early on Friday.

Gold is an inflation hedge for investors when they fear banks and government debt are no longer safe places to park their money.

Connolly says avoiding a gold price surge is another reason for authorities to act now to lower real long-term interest rates and put the economy back on firmer footing.

Connolly concedes that the U.S. dollar will fall if the Fed engages in aggressive Treasury purchases. But he says that is necessary to helping the U.S. economy recover.

“From the point of view of its own long-term best interest, and for that matter the interest of the world, the United States should depreciate the dollar,” Connolly said.

Editing by Dan Grebler

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