Bonds Tank After Lousy Bond Auction

The Treasury market plunged sharply this afternoon after one of the worst 30-year Treasury bond auctions in recent memory. Investors balked at buying the $10 billion in bonds, due to the wild vacillations in the last week and expectations that the Federal Reserve is going to raise interest rates several times in the coming months.

Traders responded to the poor results by selling positions, and the entire market collapsed as a result of the poor auction results. It should be noted that the new bond actually managed to finish the day at 6.24%, significantly lower yield than the 6.34% it was issued at, but that's the one bright spot in an environment that isn't a compelling one for investors.

The 10-year Treasury note was lately down 19/32 to 98 26/32, increasing the yield 6.3 basis points to 6.664%. The 30-year bond was hardest hit -- the bond was lately off 1 16/32 to 95 31/32, although at its lowest it was down 1 24/32. The yield rose 12.2 basis points to 6.432%. The five-year note was down 5/32 to 96 13/32 to yield 6.768% and the two-year was unchanged at 99 15/32, yielding 6.666%.

The Treasury Department sold $10 billion in 30-year notes, which, if the Treasury keeps its word, will be the only new 30-year bond sale this year. The bonds were awarded at 6.34%, the highest since Aug. 7, 1997, when the yield was 6.445%. What's especially striking, however, is that the bid-to-cover ratio (a gauge of the level of interest in the auction, measured by the number of bids vs. what the Treasury offered) was a freakishly low 1.33-to-1. The average bid-to-cover ratio for the last 10 auctions -- including this one -- was 2.242-to-1.

Some sources put the blame firmly at the feet of the Treasury Department, which some believe sent mixed signals to the market in the past week after revamping its schedule for new debt issuance.

"When investment bankers underwrite corporate issues, they give you guidance" when they are changed, said Bill Quan, senior economist at Aubrey G. Lanston. "Meanwhile, the Treasury decides to spring this on you. It's like walking with nitroglycerine -- what if you decide to short the two-year note, and the Treasury decides to eliminate it?"

Last week the Treasury announced it would sell just one new 30-year bond a year, in addition to divulging details of its planned buybacks of long-dated securities. A New York Times article last week suggested that this marked the eventual extinction of the 30-year bond, which may have been overly speculative, but it did include quotes from Treasury undersecretary Gary Gensler, who said that he expects the bond market to regard the 10-year bond as more of a benchmark.

The market was then shocked yesterday by Treasury Secretary Lawrence Summers, who told reporters that the Treasury would endeavor to manage its debt along the entire yield curve -- which suggests that the Treasury won't be eliminating the 30-year bond. "Clearly, the capital markets will need to adapt to the situation where there is reduced federal debt issuance," Summers said.

Investors aren't thrilled. "We're willing to play the role of the quote 'vigilante' as long as we don't get whipsawed, so our balance sheets don't take a whack courtesy of you guys saying something that runs counter to the generally understood game plan," said Mitch Stapley, chief fixed income officer at Kent Funds in Grand Rapids, Mich. "Clearly, over the last three weeks or so, the communications or understanding between the Street and the Treasury have been strained."

However, with the current yield on the bond is less than the rest of the yield curve, this auction just looked unattractive to investors. While that's partially due to the market's expectations for low inflation and more rate hikes from the Fed, strategists said investors aren't interested in buying the bond at these levels when it appears that the economy isn't slowing at all. For that reason, the dealers are to blame for overreacting to the Treasury's confusing pronouncements.

"Before all this started a couple weeks ago, we were up around 6 3/4% on the bond. Now, it's 50 basis points lower -- what has changed in two weeks? If anything, the economy looks stronger, not weaker," said Jim Kochan, senior bond market strategist at Robert W. Baird in Milwaukee. "And a portfolio manager is asked to ignore all that and buy the bond at 6.25%? I don't blame them for telling the dealers where they can put that idea."

Fannie Mae (FNM) sold $5.5 billion in notes and bonds earlier today. Fannie Mae sold $3 billion in five-year notes and $2.5 billion in 30-year bonds. Fannie Mae today said it would expand its benchmark sales program to include quarterly 30-year bond sales, stepping into the void created by the Treasury.

Federal Reserve Chairman Alan Greenspan testified in Washington today, but it was a nonevent. Greenspan and Treasury Secretary Lawrence Summers testified before the Senate Agriculture Committee on over-the-counter derivatives markets.

The Bank of England overnight raised its key short-term refinancing rate by 25 basis points to 6%.

Economic Indicators

Initial jobless claims rose 27,000 to 301,000 last week, from the previous week's unrevised 274,000 figure. The Labor Department attributed some of the rise in jobless claims to a bounceback in state reporting after the previous week's snowstorm.

The four-week, moving average fell to 276,250 -- the lowest the moving average has been since Dec. 15, 1973. The previous week's moving average was 278,750. This was the day's only economic release.

Tomorrow's most important release is the January retail sales report. Expectations are for a 0.6% increase in sales, according to economists polled by Reuters. Excluding autos, sales are expected to rise 0.5%.

Currencies and Commodities

The dollar was stronger against both the yen and the euro. Dollar/yen was lately up to 108.77 from 108.75 yesterday, while the euro was lately at $0.9874, down from $0.9938 yesterday.

A rally in commodities also hurt the bond market today, as gold and oil rallied sharply.

Crude oil for March delivery was up strong, closing at $29.42, up from $28.77 yesterday.

The Bridge Commodity Research Bureau Index rose to 214.97 from 210.38 yesterday.

Gold for April delivery on the COMEX closed at $318.7 per ounce, up $10.1 from $308.6 yesterday.

>To order reprints of this article, click here: Reprints