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Bond Brief: Auctioning Pain

Yields move up after indirect bidders get only 25.6% in a sale of two-year notes.

Updated from 2:30 p.m. EST

Treasuries ended near session lows Wednesday after an auction of $22 billion in two-year notes drew lower demand from indirect bidders and more supply in the pipeline weighed on prices.

The 10-year note closed down 21/32 to yield 4.48%, up from 4.39% late Tuesday. The yield was near the 4.50% level hit in November 2005. The 30-year bond plunged 1 9/32 points to yield 4.65%, up from 4.57% the previous session. Bond prices and yields move in opposite directions.

In shorter-dated maturities, the five-year note lost 12/32 to yield 4.40%, while the two-year was down 4/32 to yield 4.45%. The three-month bill was up one tick to yield 4.41%.

The new two-year notes were sold at a yield of 4.427%.

"We didn't get the participation in the two-year auction that we've been expecting from indirect bidders, a group that has supported the bond market tremendously over the last couple of years," says Steve Bohlin, a portfolio manager with Thornburg Investment Management.

Indirect bidders got 25.6% of the securities, down from 30.6% last month and far less than the average 34.62% for all 12 of 2005's two-year auctions.

Bohlin says foreign participation has waned at the last three Treasury auctions and that this could be in part because China now has $850 billion worth of dollar-denominated debt in its reserves and doesn't think that it needs to acquire much more right now. The same could be said of Japan, he adds.

For every $1 of debt on sale, there was $2.11 worth of bids, compared with $2.42 at the last two-year sale, in December. The result was the lowest since April, and also below the average over the past 12 sales of $2.20.

But Alan De Rose, a bond trader with CIBC World Markets, said that all-in-all the auction was nowhere near disastrous, and that the success of upcoming debt issuance will depend on what the

Federal Reserve

says and what the economic data looks like. CIBC is one of 22 primary U.S. government securities dealers required to participate in Treasury auctions.

"The new two-year is trading slightly richer than where it cleared at auction time; and since the auction, the price action on the two-year has been pretty much sideways," De Rose says.

What makes today's slump intriguing is the fact that the data has been on the friendly side and that the market has largely ignored it, writes David Ader, bond strategist with RBS Greenwich Capital, the securities business of Greenwich Capital. The firm is also a primary dealer in Treasury auctions.

The National Association of Realtors reported Wednesday that December existing-home sales fell by a far-larger-than-expected 5.7% to a 6.60 million annual rate, vs. Wall Street expectations for a decline to 6.87 million. Unsold-home inventories rose, sitting an average 5.1 months on the market, as the fall-off continued from June's record sales pace.

Economists are closely watching the housing sector for signs that 13 straight quarter-point rate hikes have slowed the interest rate-sensitive market.

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A housing slowdown could give way to a soft economy, since U.S. consumers have used their rapidly rising home equity to boost purchasing power and the strong market has created jobs, and cool inflationary pressures in the market. Bond investors loathe inflation because it erodes the value of fixed-income investments.

"Stocks are

also off today, and we have at least two friendly events ahead -- fourth-quarter GDP and a Fed into neutral," writes Ader. "We take away from the action in light of this information that the market had overly discounted the good news and is attempting to price in some risk premium."

Despite consensus opinions that the Fed will hit a neutral level next week by raising the overnight lending rate to 4.50%, there is still talk that the market needs to be more vigilant about another rate hike in March. The fed fund futures contract has now priced in a 72% chance for a quarter-point rise in March, up from recent 55% odds in favor of tightening.

The outlook for March will likely determine whether the long and short ends remain flat or inverted, with an inversion in the spread between 10-year and three-month yields the one that the Federal Reserve is most concerned with, according to Miller Tabak.

The brokerage firm says that once the inversion between these yields hits the midteens, in terms of basis points, odds of a recession within four quarters jump to 30%.

Bohlin said that it would make sense for some risk premium to be put back into the market, given the fact that the economy was growing nicely before the hurricanes hit this fall, and that the economy looks like it has weathered the hurricanes well.

"We'll see when we get the fourth-quarter GDP numbers on Friday, but it seems as if the economy is poised to move back toward 3.5% growth," Bohlin said. "Add in the fact that inflation has doubled over the last couple of years, and it would make sense to have a higher yield on the 10-year Treasury than what we see now."

Additional supply -- today's auction and the upcoming Treasury refunding -- will continue to weigh on prices as the market reshuffles to make room for the new securities, says Steve Rodosky, senior vice president with Pacific Investment Management Co.

Next week the Treasury will announce the size of its quarterly refunding sales of three- and 10-year notes and 30-year bonds, with Wall Street analysts estimating that the total may hit $48 billion.

A report on durable orders for December will be released Thursday morning. Wall Street analysts believe the number will rise, but not as much as November's 4.4% gain.


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orders are expected to give the durables report a lift again, with the company's strongest month of aircraft orders in six years expected to push growth in non-defense capital goods, including business spending, to a huge 35% year-on-year gain.

As prices slid in the morning, the spread between the 10-year and the two-year yields widened. Moreover, the yield on the 10-year rose above that on the three-month bill after being inverted earlier in the morning.

Yields on longer-dated Treasuries are usually higher than on shorter-dated ones to compensate investors for the additional risk of lending money for a longer period of time. However, the yields between the 10-year note and the two-year, as well as between the 10-year and the three-month, have been flat.

There have even been periods of time when yields on the short end have risen higher, "inverting" the curve. This could mean that investors see more risk in the near term, a perception that has historically preceded an economic slowdown or recession. It also accounts for the fact that yields on shorter-dated maturities are more sensitive to fluctuations in the overnight lending rate set by the Federal Reserve.

Rodosky also says not to forget that speculative selling started in German fixed-income markets and then carried over to the U.S., after the Ifo institute reported the strongest business sentiment in Germany in nearly six years.

The data fueled fears that inflationary pressures might be on the upswing in the euro zone, and that interest rates might have to head higher.