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II.
Investments Results -
First Quarter 2007
DIF
- During the first quarter of 2007, the par value of the DIF investment
portfolio increased by $568 million or by 1.22 percent—from $46.483
billion on December 31, 2006, to $47.051 billion on March 31, 2007. Moreover,
during the quarter, the DIF portfolio’s market value increased by
$730 million or by 1.49 percent, from $49.038 billion on December 31, 2006,
to $49.768 billion on March 31, 2007.
- The DIF
investment portfolio's total return for the first quarter of
2007 was 1.655 percent, approximately 10.3 basis points higher than
the return
of the benchmark, the Merrill Lynch 1 - 10 Year U.S. Treasury
Index (Index), which earned 1.552 percent during the same period. The
outperformance
relative to the benchmark can be attributed to the strong performance
of the DIF investment portfolio’s TIPS holdings, which outperformed
the benchmark’s conventional securities during the quarter.
- During
the first quarter of 2007, staff purchased Treasury securities
on two occasions, both purchases occurring in January. Staff purchased
four securities with a total par value of $1.300 billion, a
weighted
average maturity of 6.34 years, a weighted average duration
of 5.10 years, and a weighted average yield-to-maturity of 4.835
percent.
During February and March, staff continued its recent practice
of deferring purchases of longer-maturity securities and holding
excess
funds in higher-yielding overnight investments. On March 31,
2007, the DIF portfolio’s overnight investment balance was $3.709
billion, well above its $150 million target floor, and higher than
the $2.949 billion balance on December 31, 2006, meaning that staff
purchased a smaller amount of Treasury securities compared to the
amount of net cash received during the quarter.
- In line with consensus expectations, yields should continue
to trade generally within their current range, but with the potential
for a modest rise from quarter-end levels. Similar to the strategy
employed during the first quarter, during the second quarter, staff will
take
advantage of instances when yields rise toward the upper end of
this trading range and accordingly will deploy funds into longer-maturity
higher-yielding securities.
The Treasury Market
- During the first quarter of 2007, conventional Treasury yields
were little changed over the short-end of the curve and decreased modestly
across the remaining maturity sectors. This non-parallel yield curve
shift may be attributed to market expectations that the Federal Reserve
was unlikely
to cut the federal funds target rate over the near term, although expectations
for rate cuts later this year have grown stronger. The yield on the three-month
Treasury bill increased by two basis points, while the yield on the six-month
Treasury bill decreased by two basis points. The two-year note yield,
which is also sensitive to actual as well as anticipated changes in the
federal
funds rate, decreased by 24 basis points, again, reflecting stronger
consensus expectations that the federal funds target rate will be cut later
this year.
Intermediate-term Treasury yields also decreased, with the five-year
Treasury note yield declining 16 basis points and the ten-year note yield
declining
a more modest six basis points. The Treasury yield curve ended the first
quarter very flat and slightly positive; on March 31, 2007, the ten-year
to two-year yield curve spread was a positive seven basis points (compared
to a negative 11-basis point spread at end of the fourth quarter of 2006).
From a recent historical perspective, the curve remains significantly
flatter; over the past five years, this spread has averaged 123 basis points.
- During
the first quarter of 2007, TIPS real yields decreased, reflecting
concerns over weak economic growth as well as lingering inflationary
pressures.
For example, the real yield on the DIF portfolio’s longest-maturity
TIPS (with a maturity of a little under five years) decreased by 41
basis points. The real yield on the ten-year TIPS maturing on January
15, 2016, decreased by 23 basis points.
Prospective Strategies
- The current DIF investment strategy provides the flexibility to
purchase a wide range of different Treasury securities with varying maturities,
depending on Treasury market conditions and developments during the second
quarter of 2007. Similar to the first quarter 2007 investment strategy,
if higher yields become available—either as a result of an upward shift
in the yield curve or because of potential yield volatility—the second
quarter 2007 strategy provides the flexibility to purchase comparatively higher-yielding,
longer-maturity Treasury securities. Given the flat Treasury yield curve,
purchasing short- and intermediate-maturity Treasuries may also make sense.
- The DIF portfolio’s
primary reserve target floor balance will remain at $10 billion
for the second quarter
of 2007. The target limit for TIPS will also remain at its
current $10 billion target, while the AFS security target limit
is being increased from $8.7 billion to $9.0 billion to help
ensure that the primary target floor balance can be maintained
during 2007 (see attached Approved Investment Strategy).
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