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A self-styled bridge between Wall Street and Main Street is showing some cracks. Now the question is whether Washington might try to shore it up.

CIT Group (CIT, Fortune 500), the New York-based lender to small and midsize companies that got $2.3 billion in taxpayer funds in December, has been reportedly in discussions to get additional government assistance. As of late Tuesday, those discussions were still ongoing.

Though CIT’s shares gained nearly 20% Tuesday, they have plunged some 60% since the beginning of June, to just $1.60 each. And the cost of insuring against a default on its bonds has skyrocketed. The company has also reportedly hired lawyers to explore a possible bankruptcy filing.

The problems at CIT mark the administration’s first brush with financial crisis since the spring’s stock market rally.

While CIT is much smaller than Lehman Brothers, which failed last September with disastrous consequences, the debate in Washington hasn’t changed: Policymakers must weigh the health of the financial system against holding the private sector accountable.

"It’s a balancing act. Everyone has been worrying about bailouts creating moral hazard," said Douglas Elliott, a former investment banker who is now a fellow at the Brookings Institution. "At the same time, they’re still trying to rebuild confidence in the economy."

Speaking in London Monday, Treasury Secretary Tim Geithner said of CIT, "I’m actually pretty confident in that context we have the authority and the ability to make sensible choices."

Cash crunch

The immediate problems at CIT, which says it has been the top Small Business Administration lender nine years running, center on the company’s lack of access to funding.

Like many finance companies, CIT funded its operations by borrowing in the debt markets. But the collapse of Lehman all but closed those markets to finance companies — prompting CIT and bigger players, ranging from Goldman Sachs (GS, Fortune 500) and American Express (AXP, Fortune 500), to hurriedly convert themselves to banks.

But unlike those firms, CIT has not gotten access to a program that allows financial firms to issue debt backed by the Federal Deposit Insurance Corp cash advance. CIT applied in January to join that Temporary Liquidity Guarantee Program, under which banks and finance companies have issued some $285 billion of guaranteed debt since November.

But CIT’s application is still pending. And an analyst at Fox-Pitt Kelton said last month approval now appears unlikely, given the long lag since the application was filed and the agency’s desire to wind the program down. The program is scheduled to expire in October.

An FDIC spokesman said the agency has been having evaluating the exposure it would take on were it to allow CIT to issue FDIC-backed debt. The Fed said it couldn’t offer any guidance on the CIT situation.

At the same time, CIT’s finances have been weakening. It lost $438 million in the first quarter, as revenue dropped 35%. Moreover, it has $1 billion in maturing debt to pay off next month, as well as $10 billion through the end of 2010.

As a result, all the major ratings agencies have downgraded the company’s bonds over the past week. On Monday both Moody’s and S&P cut CIT’s ratings, with Moody’s citing the firm’s "inadequate progress" in boosting liquidity.

The CIT crisis comes just seven months after the firm sold stock, swapped some new debt for old bonds and submitted to regulation by the Federal Reserve in hopes of regaining its access to funding markets. Executives claimed the moves would be an "inflection point" for CIT, but events haven’t played out as they might have hoped.

"As the bridge between Wall Street and Main Street, CIT remains one of the few significant sources of liquidity for small and mid-sized businesses who are struggling to survive in today’s challenging environment," CEO Jeffrey Peek said in a statement last November, when CIT applied with the Fed to become a bank holding company.

Now, it seems, CIT is struggling to survive as well. 

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After a six-week trip through bankruptcy, the "new" General Motors was born Friday owned by the government and free of tens of billions in debt and shed of unaffordable brands, dealerships and plants.

The sale of the valuable assets of the old company to the new GM was completed Friday morning.

"This is an exciting day for General Motors, one that will allow every employee, including me, to get back to the business of designing, building and selling great cars and trucks and serving the needs of our customers," GM Chief Executive Fritz Henderson said.

"We deeply appreciate the support we’ve received. We’ll work hard to repay the trust, and the money, that so many have invested in GM," Henderson added.

But he said he couldn’t promise that GM would repay the $50 billion the government has already given or promised to GM.

"Our performance over time will determine if the taxpayers are made whole," he said.

The company hopes to beat a 2015 deadline for repaying about $6.7 billion in government loans, Henderson said.

But Treasury’s ability to recover most of the rest of the $50 billion will depend on the future market value of the government’s large equity stake. The company’s stock is not expected to trade publicly until 2010 at the earliest.

Henderson told CNNMoney Friday that he is confident the company will not need government assistance beyond the $50 billion already committed to its turnaround.

"This is a precious second chance," he said. "There are no third chances."

The new company retains the Chevrolet, Cadillac, GMC and Buick brands, along with most of its overseas operations.

GM also keeps about 3,600 of its 6,000 U.S. dealerships and most of its plants. But 14 U.S. plants will be closed, and the company will eliminate about 20,000 of its 88,000 U.S. employees by the end of the year as it continues to cut costs.

While the new company goes forward outside of bankruptcy, much of its debt and many of the assets it shed in the process remain in bankruptcy. It will take about two to three years for an entity known as Motors Liquidation Co. (GMGMQ) to liquidate under court supervision.

The company is in the process of selling its Saturn, Saab and Hummer brands. It will make its last Pontiac in September. Virtually all of the dealerships it is shedding will continue to sell GM cars and do warranty repair work into 2010, but all are expected to be discontinued by September of next year.

The new GM has a tough road ahead. The company has suffered from decades of market share losses and now accounts for less than 20% of U.S. auto sales. It retains the lead over its rivals such as Toyota Motor (TM) and Ford Motor (F, Fortune 500), although last year it lost its long-time title of world’s largest automaker to Toyota.

Despite losing that global sales title, GM’s overseas operations are generally stronger than its U instant cash advance.S. operations. Its joint ventures are a leader in sales in China, a growing market that now rivals the U.S. market in sales volume. Only about one in four of its vehicles sold in the first quarter of 2009 were in the United States.

GM has lost $88 billion since 2005 as its debt rose to an unaffordable $54 billion. Its current crisis came as a downturn in the U.S. economy and credit crunch at the end of last year caused industrywide sales to plunge.

The Treasury has pumped about $30 billion into GM to keep it alive since late last year, and will give it an additional $20 billion before the end of 2009. In return, taxpayers will own 60.8% of the company going forward. A trust fund controlled by the United Auto Workers union, which will be used to pay retiree health costs, will hold 17.5% of shares, while the Canadian and Ontario governments will own 11.7%.

The remaining 10% is expected to eventually go to GM’s former bondholders as partial compensation for their lost investment in the company. Previous GM shareholders will have no ownership stake in the new company. GM was removed as a component of the Dow Jones industrial average last month following its bankruptcy filing.

On Friday, Henderson started pulling back the curtain on a series of new initiatives.

He announced a proposed new partnership with eBay that will allow buyers in California to bid on vehicles, the way they do for other vehicles. He said the venture would "revolutionize how people buy vehicles online."

GM will also be making announcements later this summer on new battery technology to make electric and plug-in hybrid vehicles possible, Henderson said.

The company announced some key management changes Friday. Vice Chairman Bob Lutz, who had said earlier that he would retire from day-to-day responsibilities, will instead stay with the company to run products and customer relationships.

Customers need to be GM’s top priority, Henderson said. "If we don’t get this right, nothing else is going to work. It’s that simple," he said.

Henderson also announced he was reducing levels of management and several committees that had been responsible for decision making.

"Most people would say our culture to this point has been an impediment and I agree with that," he said.

Have you gone to a state or local government office only to find locked doors due to worker furloughs? Are you a public employee forced to take unpaid time off? How have furloughs affected you? We want to hear your experiences. E-mail your story to realstories@cnnmoney.com and you could be part of an upcoming article. For the CNNMoney.com Comment Policy, click here. 

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Bond investors across the country are snapping up 10-year Treasury notes as expectations for a U.S. economic recovery this year disappear.

Firms from New York-based BlackRock Inc. to Franklin Templeton Investments in San Mateo, California, are turning more bullish a month after yields on Treasuries rose to the highest since October. Declining consumer confidence, falling stocks and unemployment climbing toward 10 percent has overcome concern that record auctions of government debt will overwhelm demand. Barclays Plc estimates $1.1 trillion more sales by the end of the year, on top of the first half’s $963 billion.

The gap between yields on 10-year Treasury notes and two- year securities narrowed to 2.40 percentage points from a record 2.81 percentage points on June 5 as investors took advantage of relatively cheap longer-term debt. The so-called yield curve typically widens when investors anticipate a recovery because they demand more compensation for the risk that growth will spark inflation.

“You are starting to hear more concerns about how well the economy is doing,” said Michael Materasso, co-chairman of the fixed-income policy committee at Franklin Templeton, which oversees $128 billion in bonds.

Franklin reduced its holdings of corporate bonds that perform better than government debt in an expanding economy and added Treasuries due in about 10 years in the past two weeks, Materasso said.

Bid-to-Cover

The yield on the benchmark 10-year note fell 20 basis points, or 0.2 percentage point, last week to 3.30 percent in New York, according to BGCantor Market Data, as an auction of $19 billion of the securities drew the most demand ever. The 3.125 percent note due May 2019 rose 1 20/32, or $16.25 per $1,000 face amount, to 98 16/32. The yield was little changed today as of 12:19 p.m. in Tokyo.

The bid-to-cover ratio, which gauges demand by comparing total bids with the amount of securities offered, was 3.28 on July 8, up from 2.62 at the last auction of the notes on June 10 and above the average of 2.38 at the previous 10 sales.

Stock markets also show growing concern about a recovery. The Standard & Poor’s 500 Index fell in each of the past four weeks, declining 7 percent to 879.13.

Materasso, who is based in New York, expects the yield curve to narrow to 2 percentage points. An investor buying $100 million of 10-year notes betting on a so-called flattening will earn $4.89 million if the gap narrows to 2 percentage points, according to data compiled by Bloomberg. That assumes that the two-year note yield remains constant at 0.90 percent.

Curve Forecast

Based on the median of at least 55 estimates in Bloomberg surveys of two- and 10-year yields, the curve will shrink to 2.35 percentage points by 2010. A month ago, the median was 2.48 percentage points, while in May it was 2.15 percentage points.

Before this year, the curve peaked at 2.74 percentage points in August 2003, as economic growth surged to 7.5 percent that quarter.

So far in July, 10-year notes have returned 2 percent, the first positive month since March, when the Federal Reserve said it would buy as much as $300 billion in Treasuries to drive down borrowing costs and spur the economy, according to a Merrill Lynch & Co. index.

Yields on Treasuries rose last month to the highest relative to German bunds of similar maturity since 2007 and exceed the rate of inflation by the most since 1994.

Rising Debt Sales

Investors anticipating yields to fall from June to September, as they have in 15 of the last 20 years, may be disappointed as the Treasury accelerates debt sales to finance a budget deficit the Congressional Budget Office projects will quadruple to $1.85 trillion in the fiscal year ending Sept. 30.

The yield curve steepened in the first half as 10-year notes lost 8.7 percent and two-year securities gained 0.12 percent amid concern U.S. debt sales would push up borrowing rates as the worst recession in 50 years came to an end. The U.S. more than doubled issuance in the first half. Sales for the rest of the year would be more than the total in all of 2008, based on the estimates by London-based Barclays, one of the 17 primary dealers required to bid at Treasury auctions.

“Where do I find the going away demand to choke down four times the amount of supply in the marketplace than what they had to deal with last year?” said Mitchell Stapley, who oversees $22 billion as chief fixed-income officer at Grand Rapids, Michigan-based Fifth Third Asset Management paydayloans. “It’s a tough one.”

Fed Outlook

The Fed’s announcement June 24 that it anticipates keeping the target rate for overnight loans between banks at zero to 0.25 percent for an extended period is keeping two-year notes anchored near current levels.

Ten-year yields climbed to 4 percent on June 11 for the first time since October as investors raised concerns about President Barack Obama’s attempts to revive the economy with deficit spending. They also began to anticipate a recovery after Fed Chairman Ben S. Bernanke said in March that he saw “green shoots” in credit markets that would lead to a recovery.

The Libor-OIS spread, which measures banks’ willingness to lend, narrowed to 31 basis points, from a record 364 basis points in October.

Investors are piling back into Treasuries after consumer confidence declined in July following four months of gains. The government reported that the jobless rate rose in June to 9.5 percent from 9.4 percent the previous month.

‘Fundamental Headwinds’

“The economy still faces pretty fundamental headwinds from the employment situation and the inflation picture,” said Stuart Spodek, co-head of U.S. bonds in New York at BlackRock, which manages $474 billion in debt.

The S&P 500’s drop followed gains of as much as 40 percent since March. Investors are growing more concerned that prices outpaced prospects for a recovery from the longest slump in corporate profits on record.

Investors demand 10.89 percentage points more in yield to own high-yield, or junk, bonds rather than government debt, up from this year’s low of 10.4 percentage points June 15, Merrill Lynch & Co. indexes show.

Doubts the economy will recover this year are showing up in the currency market, where the yen appreciated to 128.95 per euro from this year’s low of 139.22 on June 5. The yen typically strengthens when investors unwind investments in higher-yielding assets financed with yen.

‘Classic Indicators’

“Classic indicators of risk aversion such as euro-yen have continued to show strong hints of rising,” William O’ Donnell, head of Treasury strategy at RBS Securities Inc. in Stamford, Connecticut, wrote in a note to clients July 10. “There’s every indication that investors are questioning the strength of the green shoots rebellion hatched this spring.”

Investors have also become more bullish on longer-maturity debt after the Fed tempered inflation expectations at its June policy meeting.

“Substantial resource slack is likely to dampen cost pressures,” the Federal Open Market Committee said in a statement after meeting June 24. “Inflation will remain subdued for some time.”

The gap between rates on 10-year notes and Treasury Inflation Protected Securities, or TIPS, which reflects the outlook for consumer prices, narrowed to 1.51 percentage points today, the least since May 14, from a nine-month high of 2.13 percentage points June 10.

“As commodity prices continue to come off and TIPS breakevens continue to come off, you should see some of that risk premium taken out of 10-year yields,” said Todd White, who oversees government debt trading in Minneapolis at RiverSource Investments in Minneapolis, which manages $86 billion of bonds.

Relative Bargain

Treasuries are a bargain compared with European debt and inflation. Yields on 10-year notes rose last month to 28 basis points more than bunds, the highest since October 2007. As recently as December, Treasuries yielded 28 basis points less than bunds.

The cost of living in the U.S. fell the last 12 months by the most in six decades, the Labor Department said June 17. The government will report the measure on July 15. Prices rose 0.6 percent in June, according to a Bloomberg survey of 16 economists.

Yields on 10-year notes exceeded the consumer price index for the trailing 12 months by 5.25 percentage points, the most since November 1994, when the gap was 5.38 percentage points.

“The trend is for no V-shaped recovery and subdued global growth and therefore no inflation,” said Michael Cheah, who manages $2 billion in bonds at SunAmerica Asset Management in Jersey City, New Jersey. “I’m betting the curve will flatten again.”

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Former Federal Reserve Chairman Alan Greenspan said the credit crunch should be over by now. But just ask anyone who has tried to get a loan recently, and they’ll tell you a different story.

Greenspan’s measure of credit flow, a gauge known as the Libor-OIS spread, fell to 0.33 percentage points on Thursday — its lowest level since February 2008 and just eight-hundredths of a point above the 0.25 level that the Maestro called "normal."

So are things back to normal? There’s no easy answer.

"It’s more complicated than that, obviously," said Scott Anderson, senior economist at Wells Fargo. "Greenspan’s right in one respect: the liquidity crisis is over. But consumers’ and business’ access to credit remains extremely tight."

The "credit crunch" began in the fall of 2007, when the housing market began to unravel and the value of many mortgage-backed securities, held by most banks, started to tumble. With losses piling up at financial institutions, banks tightened their lending standards and offered more conservative loan products to customers.

The crunch escalated into a "liquidity crisis" last September, after Lehman Brothers collapsed, worrying banks that their lending partners might not be around when it came time to repay their loans. Banks sat on their reserves, interbank lending came to a virtual standstill, and the premium on short-term loans went sky-high. Banks turned to issuing debt rather than making loans to stay afloat.

The crisis has passed, experts say. But the crunch is here to stay for awhile.

Why the liquidity crisis is over. Beginning in October, the Fed unveiled nearly a trillion dollars in liquidity programs, and the Treasury Department lent hundreds of billions of dollars in TARP funds to banks. Both efforts were aimed at getting banks to lend to one another again.

Experts say the programs have largely worked: Banks have started repaying their TARP funds, interbank lending has increased and the Libor-OIS spread has fallen back to normal.

The Libor-OIS spread is a good credit market gauge because it measures the difference between what banks are actually charging each other for three-month loans and what traders believe the baseline Fed rate will average over the course of the loan.

Banks charge a lot more than the Fed wants them to charge when credit is tight, because of supply and demand: When no one is issuing loans, they can charge whatever they want business cards online. When everyone is lending, they have to be competitive.

"The systemic risk in the banking system has been mitigated," said Andrew Brenner, senior vice president of MF Global. "There’s been huge move away from banks having to issue debt to stay alive, and banks that were firing are hiring again."

The spread averaged 0.11 percentage points over the four years before August 2007. That increased to about 0.85 points just before Lehman’s meltdown. In mid-October, before TARP was doled out and the Fed’s liquidity programs began, the spread rose to a record 3.65 points. But it has fallen steadily since then.

Why the credit crunch is still here. If banks are healthier, why haven’t we noticed?

Mostly, because the economy still stinks. With unemployment levels closing in on 10%, household wealth deteriorating, foreclosures still rising and credit delinquencies at a record high, banks aren’t quite ready to fork over their dough to you without being absolutely sure you can pay it back.

Accordingly, the Fed reported Wednesday that consumer borrowing fell by $3.22 billion in May after dropping a record $16.5 billion in April.

Furthermore, just because liquidity is essentially back to normal, that doesn’t mean that financial institutions are healthy again. Losses are still mounting, markets are still volatile and banks are still hanging onto billions of dollars in toxic assets.

"There’s a long way to go," said Anderson. "Banks still have a lot of losses to make up."

Will it get better?

"Absolutely. Everything goes in cycles," said Brenner, who predicts the credit crunch will end in about a year. "These low rates will probably spur inflation at some point, and banks will make more money."

But some aren’t so sure the future will look like the past.

"It won’t ever go back to the way it was before the crisis erupted in the fall of 2007," said Anderson. "There’s a new normal as far as banks are concerned, in terms of tighter standards and the types of loan products offered." 

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Aluminum producer Alcoa Inc. reported its third quarterly loss in a row Wednesday, as the global recession has crippled demand for the lightweight metal.

The stock surged in after-hours trade, adding as much as 9%. In regular session trade, shares of Alcoa added 5 cents to close at $9.46.

Alcoa has cut costs aggressively in the face of sharply slower demand, but with inventory levels low and the global economy showing signs of recovery in the longer term, executives said they were seeing signs of stabilization.

In the three months ended June 30, Alcoa (AA, Fortune 500) lost $454 million, or 47 cents per share, compared with a profit of $546 million, or 66 cents per share, in the same period a year ago.

Excluding one-time restructuring charges and losses from discontinued operations, the company posted a loss of 26 cents per share, which was better than the forecast for a loss of 38 cents a share from analysts polled by Thomson Reuters. Analysts typically exclude one-time charges from their estimates.

Sales fell 41% to $4.24 billion from $7.62 billion last year, beating analyst expectations of $3.93 billion.

The company blamed the loss and drop in sales on a slowdown in the industries for which it provides raw materials — including automotive, commercial transportation, building, construction and aerospace — as well as a 49% drop in metal costs.

The company boasted that its cost-cutting initiatives — such as previously announced headcount announcements and production cut-backs — were boosting its balance sheet.

"Our cash generation initiatives, productivity improvements, and portfolio changes are working," said Klaus Kleinfeld, Alcoa President and Chief Executive Officer, in a written statement. "Now Alcoa has the staying power and reduced cost base to withstand the most serious downturn in the history of the aluminum industry."

Alcoa has been especially aggressive in reducing its head count. In the last year, the company has identified 21,650 jobs that it plans to cut, and so far, the company has already eliminated 18,375 of those planned cuts, said Chuck McLane, Executive Vice President and Chief Financial Officer, in a conference call after the release of the financials were released new car loans.

The company had to slash headcounts to navigate the downturn, but going forward, the company plans to operate at tighter standards.

"More important is how many of these reductions are permanent and how many would be added back once markets recover," said McLane. "Although it’s not an exact science, we estimate that 75% of the positions are permanent reductions."

Demand for aluminum will continue to be weak in the near term. Global demand for aluminum consumption will be 7% lower in 2009 compared to 2008, according to Klaus on the conference call, but he also say signs of a recovery in demand in the longer term.

For example, demand has been so low for big ticket items that manufacturers have been forced to scale back production. But with inventories low, manufacturers will have to ramp up production when demand does recover.

Stimulus programs will also begin to produce demand. For example, Klaus cited the "Cash for Clunkers" stimulus program that President Obama recently signed, which should bring some demand to the auto industry starting at the tail end of 2009.

Furthermore, Klaus is optimistic about the longer-term demand to come out of the growing Chinese economy. Klaus said that the stimulus bill that China passed was having a positive effect on that economy.

"We are actually seeing some signs of stabilization," said Klaus.

Alcoa is the first Dow component to release its second-quarter numbers. Investors look to the aluminum producer as a barometer of how corporations are faring during the recession. 

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The biggest gilt investors say U.K. government securities provide little value even though the Bank of England will likely extend its bond-purchase program.

The U.K.’s growing budget deficit and the central bank’s reluctance to say when and by how much it will expand so-called quantitative easing are keeping Pacific Investment Management Co., which runs the world’s biggest bond fund, and BlackRock Inc. from increasing their holdings of the securities.

Guessing which gilts the central bank is going to buy is like “playing Russian roulette,” said Philip Laing, the Edinburgh-based director of government bonds at Standard Life Investments, which has about 118 billion pounds ($191 billion) under management. “While they’ll probably extend it, we are focused on the end of quantitative easing.”

Investors are losing confidence in Prime Minister Gordon Brown’s economy as the government embarks on the biggest fund- raising effort in Britain’s history. The Treasury plans to sell a record 220 billion pounds of gilts this fiscal year to fund bank rescues and stimulus programs designed to pull the economy out of its deepest slump since World War II.

Yields on 10-year gilts will likely rise to 3.97 percent in June from 3.61 percent yesterday, according to the median estimate of seven strategists and economists surveyed by Bloomberg. Foreign investors cut their gilt holdings since the start of quantitative easing, selling 10.9 billion pounds of the securities in April, the most since at least 1982, according to central bank data. They sold 960 million pounds in May.

Extending Purchases

The Bank of England bought 107 billion pounds of gilts and almost 3 billion pounds of corporate bonds and commercial paper as part of a 125 billion-pound asset-purchase plan to reduce borrowing costs and stave off deflation. The bank has permission from the Treasury to increase that to 150 billion pounds if required.

The central bank may say it intends to take up that option after its monthly interest-rate meeting today, according to Stephen Nickell, a former member of the Bank of England’s Monetary Policy Committee.

“They still have a little bit left of the 150 billion, and I expect them to use it,” he said in an interview on July 7. “It’s possible” the central bank will even ask to spend more than 150 billion pounds, he said.

All 54 economists in a Bloomberg survey said policy makers will keep their key rate at a record low of 0.5 percent.

Extended Recession

The U.K.’s recession extended into a fifth quarter during the three months ended June 30, according to the National Institute of Economic and Social Research. House prices fell in June, a sign Britain has yet to shake off the property slump as unemployment increases, a report by Halifax, a division of Lloyds Banking Group Plc, showed yesterday.

Brown’s Labour Party has the support of 25 percent of voters, compared with 38 percent for David Cameron’s Conservatives, according to a YouGov/Telegraph survey on June 25. The poll showed the Conservatives extended their lead from seven points in December. U.K. parliamentary rules require Brown to call a general election by June of 2010.

The yield on the benchmark 4.5 percent gilt due March 2019 plunged 58 basis points, or 0.58 percentage point, to 3.06 percent in the two days after Bank of England announced the quantitative easing plan on March 5. It then rose as high as 4.08 percent by June 11 as optimism that the global economy was starting to recover sapped demand for the safety of government securities.

‘Layer of Complexity’

The yield has since fallen to 3 instant payday loans.61 percent, as stocks declined amid signs that the economic recovery is sputtering, while the pound has dropped 2.3 percent since trading at a high this year of $1.6743 on June 30.

Buying securities of nations involved in quantitative easing “adds another layer of complexity” to investment decisions that are already difficult given the competing forces of an unfavorable economic outlook and increased debt supply, said Andrew Balls, a managing director in London at Newport Beach, California-based Pimco. “We prefer German bunds over gilts and Treasuries.”

German government bonds returned 0.4 percent this year, compared with losses of 1.6 percent from gilts and 3.9 percent on U.S. Treasuries, according to Merrill Lynch & Co. indexes. The German 10-year note yielded 3.27 percent and the equivalent Treasury 3.30 percent yesterday.

Targeted Securities

Should the central bank expand purchases beyond 125 billion pounds, it’s likely to start outside the current range of maturities targeted, according to New York-based BlackRock, the world’s third-largest custodian of financial assets, and Kokusai Asset Management Co. in Tokyo. BlackRock and Kokusai are among the top 10 holders of gilts by value, according to data compiled by Bloomberg.

The Bank of England excluded the 5 percent gilt due 2014 and the 8 percent security maturing in 2021 from its so-called asset-purchase facility “until further notice,” the central bank said on June 25. Policy makers will take into account the size of gilt purchases by the bank relative to the amount in circulation when deciding whether to withdraw them from the program, it said.

“They are running up against owning too much of any one particular security,” said Scott Thiel, the London-based head of fixed-income at BlackRock, which overseas more than $2.7 trillion. “If they were to expand it, they would probably go in both directions, down to two years and up to 30. We favor long Treasuries and bunds versus long gilts.”

Kokusai’s Concern

The Bank of England will probably start buying longer- maturity gilts, although not immediately, said Masataka Horii, who overseas $47 billion as a manager of the Kokusai Global Sovereign Open fund in Tokyo.

He’s avoiding longer-dated gilts, “because we’re concerned about the budget deficit,” Horii said.

U.K. Chancellor of the Exchequer Alistair Darling said on April 22 the budget shortfall in the year through March 2010 will reach 12.4 percent of gross domestic product, the most among the Group of 20 nations.

Britain is borrowing record amounts after rescuing financial institutions including Northern Rock Plc and Royal Bank of Scotland Group Plc. The Treasury, in the budget submitted to Parliament in April, estimated the bailout may cost taxpayers 50 billion pounds. The International Monetary Fund’s estimate is about 132 billion pounds.

The British economy contracted 2.4 percent in the first quarter, the most since 1958, the Office for National Statistics in London said June 30. Gross domestic product will shrink 4.3 percent this year, the Organization for Economic Cooperation and Development said last month.

“The Bank of England will want to keep some ammunition for a worst-case scenario, so there’s certainly a high degree of probability that they will extend the quantitative easing program,” said Brian O’Reilly, head of research at UBS Wealth Management in London. “We could very well see the program extended to 200 billion pounds in total.”

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South Korea’s economy will shrink less than previously expected this year and rebound at a faster pace in 2010 as government spending and lower borrowing costs drive a recovery, the International Monetary Fund said today.

The central bank should keep its interest rate unchanged at a record-low 2 percent following the 3.25 percentage points in reductions since October last year and the government should maintain fiscal stimulus through 2010, Subir Lall, division chief for the IMF’s Asia-Pacific department, said in Gwacheon.

The fund forecast gross domestic product will contract 3 percent in 2009 before expanding 2.5 percent next year, compared with its April estimates of a 4 percent decline and 1.5 percent growth respectively. The Kospi stock index climbed 28 percent this year as government relief measures helped the economy avoid following Taiwan, Japan, and Singapore into recession.

“The authorities’ rapid and comprehensive fiscal, monetary and financial policy response helped limit the depth of the downturn in the wake of the global financial turmoil,” the IMF said in a statement today following a two-week review of Asia’s fourth-biggest economy.

“The outlook is, however, subject to substantial uncertainty although overall risks are now titled slightly to the upside cash loans in 1 hour.”

All 15 economists surveyed by Bloomberg News forecast the central bank will leave its key rate unchanged for a fifth month on July 9. The government has pledged more than 67 trillion won ($53 billion) in stimulus measures and also set up funds to replenish Korean lenders’ capital and buy distressed assets.

Exports Rebound

Exports, which are equivalent to about half of GDP, climbed 17 percent in June from the previous month to the highest level since October and factory production increased for a fifth month in May from April, reports last week showed.

The government last month raised its GDP forecasts, saying fiscal stimulus and lower rates are stoking consumer confidence. The economy will shrink 1.5 percent this year and grow 4 percent in 2010, the finance ministry said in its semiannual outlook.

South Korea avoided a technical recession in the first quarter, with GDP edging up 0.1 percent from the previous three months, when it shrank 5.1 percent.

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Iceland’s central bank should focus on supporting the krona when deciding monetary policy, an International Monetary Fund spokesman said, signaling the fund wants policy makers to keep interest rates on hold today.

“The monetary policy advice of the fund is to use stabilization of the exchange rate as the principal instrument to stabilize inflation,” said Franek Rozwadowski, the Washington-based Fund’s representative on the island, in an interview in Reykjavik yesterday.

The central bank last month lowered the benchmark to 12 percent, the fourth reduction since the island came under IMF administration at the end of last year when the failure of its biggest banks precipitated the collapsed of the krona. Even with capital controls in place, the krona has slipped 4 percent against the euro since June 1, the worst performance of the 18 emerging market currencies tracked by Bloomberg.

The central bank announces its rate decision at 9 a.m. in Reykjavik today. Two of three economists surveyed by Bloomberg expect no change, while one expects a cut to 11 percent.

The currency “is what should drive monetary policy, including interest rate policy,” Rozwadowski said.

Sedlabanki interim Governor Svein Harald Oygard said on June 4 that it’s the central bank’s “privilege” to set benchmark interest rates, adding that policy makers’ decision to lower the key rate last month was mainly steered by the outlook for the domestic economy.

Lawmaker Doubts

Oygard will be succeeded on Aug. 20 by Mar Gudmundsson, a former chief economist at the central bank who currently works as deputy head of the monetary and economic department at the Bank for International Settlements in Basel.

The government of Prime Minister Johanna Sigurdardottir is struggling to get lawmaker approval for an accord struck with the U instant payday loan.K. and the Netherlands last month to cover internet deposits stemming from failed lender Landsbanki Islands hf.

Twenty-nine opposition lawmakers in the 63-seat Reykjavik- based parliament have said they will block the Icesave accord reached by the government. Four members of the junior ruling coalition partner have expressed doubts about the agreement.

Finance Minister Steingrimur Sigfusson said on June 29 he hopes the bill will pass in two weeks. The government has no “Plan B,” should the bill fail, Sigurdardottir has said.

Iceland is relying on a $2.1 billion IMF loan to avert default and received the first $827 million installment in November after the loan was approved, with a further eight equal disbursements yet to be paid. The Nordic states of Sweden, Norway, Finland and Denmark this week signed off on a further $2.5 billion in loans, and said that disbursement remains contingent on IMF reviews.

Nordic Loans

“The Icesave agreement is not part of the letter of intent for the review and the approval of this agreement in the parliament is not an explicit condition for the review,” Rozwadowski said. “However, the Nordic countries have signaled that a solution to Icesave is a condition for disbursing the loans that were signed, and these loans are needed as part of the financing of the program.”

A parliamentary rejection of the Icesave accord struck with the U.K. and the Netherlands “would create a good deal of uncertainty,” Rozwadowski said. “One question would be how the Nordics would react? Another question, for the broader membership of the Fund, would be: what does a no vote imply about Iceland’s commitment to meet its international obligations.”

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