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Bonds Fall Sharply as Fed Ramps Up Liquidity

Treasury prices sold off sharply Tuesday after the Federal Reserve and other major central banks unveiled a plan to offer up to $200 billion in Treasurys to cash-starved financial institutions.

The liquidity effort, called the Term Securities Lending Facility, is the latest central bank program designed to provide necessary operating capital to banks and keep financial markets in order. Defaults on bad mortgages and other credit assets have caused a liquidity crunch that has hurt lending, rattled nervous global markets and strained an already slowing economy.

The new program will offer Treasury bills to primary dealers through four-week auctions, a marked change from a current program that operates only on an overnight basis. In essence these auctions, to be held weekly, will provide one-month loans to the major investment firms that work with the Fed and recently have struggled to function with declining liquidity.

The program will accept a broad range of collateral, including federal agency debt and mortgage-backed securities of Fannie Mae and Freddie Mac. This should be a major boon to financial markets which in recent sessions have recoiled from many forms of mortgage debt, a development that forced such firms as Carlyle Capital Corp to miss margin calls on mortgage debt.

Although the $200 billion on offer will be in the form of Treasurys, government bond prices slipped badly as investors for the moment hunted for investments with more promising profit potential. The news also brought relief to the badly battered dollar.

The benchmark 10-year Treasury note fell 1 4/32 to 99 11/32 with a yield of 3.57 percent, up from 3.46 percent late Monday, according to BGCantor Market Data. Prices and yields move in opposite directions.

The 30-year long bond lost 27/32 to 97 21/32 with a yield of 4.52 percent, down from 4.47 percent.

The 2-year note gave up 15/32 to 100 19/32 with a yield of 1.68 percent, up from 1.49 percent.

The latest auction program shows that the Fed and other central banks are determined to find ways to boost liquidity beyond the conventional tactic of cutting interest rates. The Fed is working in concert with the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank.

The Fed is scheduled to hold a monetary policy meeting next Tuesday. Prior to the auction announcement, investors had expected a rate reduction of up to 0.75 percentage point.

"The odds on a 75 basis points (0.75 percentage point) ease next week have dropped sharply too; the Fed will be happy," said Ian Shepherdson, chief U.S. economist at High Frequency Economics. "This will not turn the economy around or fix all the problems in the markets but it should reduce the liquidity issue, at least for now."

The Fed may be looking for ways to avoid further drastic rate cuts in the Fed funds target rate, currently at 3 percent. This is because the rate cuts, along with a vigorous commodities rally, are blamed for unloosening a brisker rate of inflation in the economy.

On Tuesday crude for April jumped to a new record price of $109.72 a barrel in New York trade, indicating the commodities rally has yet to crest.

Separately, the Commerce Department reported that the nation's trade gap widened a bit in January, after higher oil prices reduced the impact of stronger U.S. exports. The trade gap rose 0.6 percent to $58.2 billion in the first month of the year.

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