Bond Brief: Auction Anxiety

Treasuries shake off a lackluster three-year note sale as weakness in stocks and housing puts a floor under bonds.
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Updated from 2:17 p.m. EST

Treasuries ended the session mixed Tuesday and the yield curve steepened a bit after the market digested the Treasury's $21 billion three-year note auction, bad news for the housing sector and a tough day for stocks.

The benchmark 10-year note ended down 6/32 of a point to yield 4.57%, while the 30-year bond slid 16/32 to yield 4.65%. Bond prices and yields move in opposite directions.

The five-year lost one tick to yield 4.52%, while the two-year note added 1/32 to yield 4.60%.

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-year for the last few sessions, "inverting" the curve and implying that investors see more risk in the near term. The curve between 2- and 10-year notes ended the session inverted by 3 basis points, vs. nearly 8 basis points intraday.

Treasury yields did not move dramatically after the auction results were announced, even though at first blush the numbers looked disappointing.

"Even when nothing moves, something's happening. And there are ways of interpreting it," says David Ader, bond strategist with RBS Greenwich Capital.

"This auction was not a comment on the general trend in Treasury issuance. What you're seeing is a comment on how the market is going to handle duration," he says, referring to a measure of a bond's price sensitivity to changes in interest rates.

Ader adds that while the auction wasn't strong

per se

, "there has been good activity trading around the issue and the front end is outperforming."

After last week's flattening and inversion in the curve due to a rally on the long end, shorter-maturity debt yields ticked lower and helped to steepen the curve a bit.

In the Treasury's largest three-year auction since May 2005, the note yielded 4.595% vs. expectations for 4.59% with a 2.03 bid-to-cover ratio. The 12-month bid-to-cover average is 2.10.

Moreover, indirect bidders only made up 22% of the demand, compared with an average of 36.8% over the last 11 auctions.

The results were little to write home about, but expectations for the issue had been moderated on talk that the auction would be soft.

Steve Ricchiuto, chief U.S. economist at ABN Amro, says this could be the worst of the three auctions. Like Greenwich Capital, ABN Amro is one of 22 primary dealers obligated to participate in government refunding auctions.

"There is reason for buyers to pick up longer-duration

debt for asset liability matching," says Ricchiuto, including pension funds and central banks as likely buyers of longer-maturity paper. But "you're not going to buy the three-year for those reasons."

Ricchiuto adds that Wednesday's $13 billion 10-year auction may suffer a bit because people will be unsure about demand for the long bond, which is the last of the three auctions.

"The 30-year will clear out very quickly," he says, referring to the $14 billion auction to be held Thursday.

For all of the auctions, the market will scrutinize demand from indirect bidders, which include both foreign buyers and pension funds.

Foreigners have played a key role in Treasury auctions because their share of the market has increased to 52% as of November 2005, up from less than 35% in 2001. Their buying of Treasuries has kept long-term rates low in the U.S., fueling sectors including housing and consumer spending.

News that Nippon Life Insurance Co., Japan's biggest life insurer, announced it may buy more euro-denominated debt this year to shift risk away from the dollar may have weighed on Treasury markets. The company's investment planning department oversees about 46 trillion yen in assets, and Japanese investors are the largest foreign holders of U.S. Treasury debt.

But Ricchiuto says that while foreign investors may diversify out of the dollar over time, "it's not going to manifest itself all at this auction."

Weakness in stocks and bad news from the nation's largest luxury home builder also helped keep a floor under Treasuries.

Toll Brothers

(TOL) - Get Report

said first-quarter orders fell 29%, its first drop in three years, and cut its sales forecast for the year.

A housing slowdown seems a foregone conclusion, and economists are debating just how soft the market will become and if it will mean a severe cutback in consumer spending.

"We can't hold at the pace we had last year,'' David Seiders, chief economist for the National Association of Home Builders, said before Toll's announcement. "It's not going to be the end of the world -- it's going to be a simmering down to a very healthy pace."