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Bond Brief: Auction Anticipation

The 10-year Treasury slips while the yield-curve inversion widens as more Fed tightening is seen.

Updated from 12:06 p.m. EST

Treasuries edged lower Monday as the market looked ahead to this week's sale of $48 billion in Treasury debt and began to price in greater odds that the

Federal Reserve

has two more interest rates in hand.

The 30-year bond was unchanged from late Friday to yield 4.62%, erasing morning gains that briefly pushed the yield below 4.60%. Meanwhile, the price on the benchmark 10-year note ended near session lows, down 6/32 of a point to yield 4.55%. Bond prices and yields move in opposite directions.

The five-year fell 4/32 of a point to yield 4.51%. The two-year lost 2/32 of a point to yield 4.61%, 6 basis points more than the 10-year yield and just below the yield on the 30-year.

Longer-dated maturities usually yield more to compensate investors for taking on the additional risk of a longer-term loan. But the two-year yield has risen above that on the 10 for the last few sessions, "inverting" the curve and implying that investors see more risk in the near term. And the spread between the two-year and the 30-year has narrowed dramatically, losing nearly 24 basis points in just over a week

Yield-curve inversion has historically preceded an economic slowdown or recession.

Rising demand for the 30-year bond could be one factor keeping yields on the long end low, exacerbating the inversion, says Rick Klingman, chief Treasuries trader at ABN Amro.

"Ever since late last week there's been pretty heavy buying in the 30-year sector," Kingman says. "Pension funds need the 30-year, and the dealer community could also be short on the issue."

Congress is working on legislation that could force companies to fully fund pension plans, and the Bureau of Labor Statistics estimates that the 29,651 companies that offer retirement plans had a $450 billion shortfall last year.

Klingman adds that 30-year assets are in short supply globally, and that many markets are seeing a yield-curve inversion.

"The 30-year is the hot IPO of 2006," says Matthew Smith, a fixed-income portfolio manager and vice president of Smith Affiliated Capital.

"Two weeks ago, Southern California Edison came out with a small 30-year issuance, and it was six times oversubscribed," says Smith. "There is demand for long bonds ... the Treasury's 30-year will no doubt be oversubscribed, too."

The Treasury will hold auctions for $21 billion of three-year notes tomorrow, $13 billion of 10-year notes the next day and $14 billion of 30-year bonds on Thursday, the first bond auction since August 2001. The government plans to borrow a record $181 billion this quarter.

"We do not take the

30-year bond's action as clean evidence of strong underlying demand for everything else," writes David Ader, bond strategist with RBS Greenwich Capital.

"Today's volume, for instance, was a paltry 68% of average. To us that suggests people are willing to stand aside, not chase anything other than bonds, and is a precursor to soft auction demand in threes and 10s," he writes.

The Treasury may get bids for as much as three times the amount of 30-years it plans to sell, according to a report from Barclays Capital. Greenwich Capital and Barclays are among the 22 primary dealers that must bid at government auctions.

Speculation that the central bank may continue to hike the fed funds rate over the first half of the year could also have kept yields on the two-year high. Shorter-dated debt, which is most sensitive to changes in changes to the overnight lending rate, is likely to trade equal to or cheaper than the fed funds rate, which was just raised to 4.5% on Jan. 31.

Interest-rate futures show traders are pricing a 90% chance the

Federal Open Market Committee

will raise the federal funds rate to 4.75% at its March 28 meeting, up from around 50% just a few weeks ago. Moreover, the odds of a hike at the May 10 meeting rose to 44% from 0% two weeks ago.

The new futures forecasts come on the heels of an unexpected drop in fourth-quarter productivity, strong wage growth and a lower unemployment in the month of January.

The data suggest that rising inflationary pressures from labor costs could lead new Fed chairman to lift rates beyond market forecasts.

Meanwhile, the Commerce Department said that gross domestic product rose by just 1.1% in the fourth quarter of last year, the slowest pace in three years. But several economists have predicted that we'll see a strong bounce in the first quarter, and J.P. Morgan Chase has increased its forecast for first-quarter growth to 5% from 4%.