Bonds Go Down, Up, and Down Again

All the while, a quirk in the Treasury refunding announcement made for strange trading in the 10-year note.
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Treasury securities traded in a wide range Wednesday -- opening weaker after another Japanese government bond market selloff, strengthening after the

Treasury Department

announced the details of next week's quarterly refunding, and finally weakening again as stocks surged.

As expected, the


monetary policy committee

concluded its first meeting of the year without adjusting the 4.75% fed funds rate. No major economic indicators were released.

All the while, the most interesting trading of the day (to traders, it was maddening) was in the 10-year note, due to an oddity in the refunding announcement.

The benchmark 30-year bond finished the day down 6/32 at 99 28/32, lifting its yield 1 basis point to 5.26%. It was down as much as 1 2/32 overnight, and up as much as 10/32 around noon.

Expectations as reported by


The Japanese government bond selloff, while mild compared with yesterday's, nonetheless prompted some selling of Treasuries overnight, market watchers said. The yield on the benchmark 10-year JGB rose from 2.30% to 2.35%, the highest since June 1997. "There's a lot of selling in Japan overnight these days," said Mark Mahoney, Treasury market strategist at

Warburg Dillon Read

. "The losses are building up so much in JGBs that they need to book some profits against those losses for their year-end." Japan's fiscal year ends March 31.

Then came the refunding announcement at 9:30 a.m. The Treasury's quarterly refunding is its auction of new 30-year bonds and long-dated notes. The refunding itself will take place next week. Today, the Treasury

announced the details.

It's going to issue $10 billion of 30-year bonds, $10 billion of 10-year notes and $15 billion of five-year notes. That compares to $10 billion of bonds, $12 billion of 10-year notes and $16 billion of five-year notes at the last quarterly refunding.

The market likes it when refundings shrink, since shrinking supply helps keep prices up. But what really lit a fire under Treasuries was Assistant Treasury Secretary Gary Gensler's announcement that the department is considering reducing the frequency of its 30-year bond and two-year note issues. Because the federal government has started to run surpluses instead of deficits, its borrowing needs are shrinking. The Treasury currently issues 30-year bonds at three of its four quarterly refundings, and two-year notes monthly. As a result of the annoucement, those issues were the best performers on the day, seeing their yields rise less than those of the five- and 10-year notes.

The quirk in the refunding announcement that made for strange trading in the 10-year note was this: The Treasury said it would "reopen" the active 10-year note, rather than issuing a new one. In other words, instead of creating a brand new 10-year note that would mature in February 2009, it would create $10 billion more of the active 10-year note, which matures in November 2008. The new issue would actually be a 9 3/4-year note.

But, the department said, it will reopen the active 10-year only if the price of the active note is at least 98. Today, the 10-year finished the day at 99 12/32 to yield 4.83%. At a price of 98 it would yield 5%. Could it fall that far before next week? "There's a payroll report -- who knows?" said Kevin Logan, senior market economist at

Dresdner Kleinwort Benson

, referring to the January

employment report

due out on Friday. The December jobs report was much stronger than expected, and bond prices dropped sharply.

The Treasury would like to reopen the active 10-year because the issue is in short supply. But they can't reopen it if its price falls below 98 for tax reasons.

The announcement is troubling for traders because once the Treasury announces the details of a refunding, they start trading the soon-to-be-issued bonds and notes on a "when-issued" basis. They price the when-issued bonds and notes based on three factors: maturity, liquidity and cost of carry.

Based on its longer maturity, a when-issued security that's not a reopening should trade at a higher yield than the most recent issue. At the same time, traders will sacrifice some yield to buy a when-issued security that's not a reopening, since the newest Treasuries are the most liquid issues. Finally, there's cost of carry: A when-issued security doesn't start paying interest until it's issued. For that reason, traders want a higher yield.

Traders compute those three factors to determine how much to pay for a when-issued security. The problem this time: They don't know the maturity of the new 10-year for sure, and they don't know whether to pay up for liquidity. "It's creating a lot of uncertainty in the trading of the security right now," said Charles Parkhurst, co-head of government bond trading at

Salomon Smith Barney


For now, traders are betting that the Treasury will reopen the existing 10-year. The when-issued note is trading at a yield of 4.85%, compared to 4.84% for the active 10-year. The 1-basis-point difference represents the cost of carry. Traders aren't paying up for liquidity, the way they are for the when-issued five-year note and 30-year bond. The when-issued five-year is trading at 4.70%, compared to 4.74% for the active issue. And the when-issued 30-year is trading at 5.19%, compared to 5.26% for the active bond.

Expectations as reported by