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Investors Take Advantage of Auction and Whack Bonds

A big rally in stocks didn't help matters.

No, today's Treasury auction of two-year notes didn't stink. Everything that happened after that was another matter.

Treasury prices tumbled after the conclusion of the sale of $15 billion in two-year notes. Traders used the auction as a perfect opportunity to reverse a so-called curve-flattening trade, which involves selling two-year notes and buying 30-year bonds.

As this selling ensued, over in the equity market all major indices rallied, pulling more money out of the bond market. It looks like a pretty bad day overall, but nothing's really changed: the market is nervous that the


will raise interest rates, and it lost money today to people looking for a buying opportunity in equities.

"There's skittishness in the market at this juncture," said Jack Malvey, chief global fixed-income strategist at

Lehman Brothers

. "The equity market is up nicely here, and there's a better taste in the

corporate sectors, so the risk aversion trade might have abated slightly."

Of late, the 30-year bond was trading at 92 7/32, losing 21/32. The yield rose 5 basis points to 5.80%.

The new two-year note sold at a high yield of 5.315%, a little lower than expected, which means buyers bid aggressively. The bid-to-cover ratio, which measures the demand for the Treasury notes, was 2.02 to 1, better than last month's 1.83 ratio, but it was only judged mildly successful.

"The results weren't all that bad," said Roseanne Briggen, market strategist at

MCM Moneywatch

. "But the only people buying the two-year notes were the arbitrage accounts, so they unwound their whole trade -- that's why the long end fell apart."

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One trading strategy at work during the last few weeks has been a curve-flattening trade, where investors bet that the yield spread between long- and short-dated securities will narrow. Once the spread narrows to a certain point, they will reverse their positions to make money off the trade.

On May 12, the difference in yield between two-year notes and 30-year bonds was 0.66%, or 66 basis points. That narrowed to 52 basis points this Monday and 45 basis points before today's auction. However, those applying this trade knew buyers were ready for the $15 billion in notes hitting the market today, and that runs counter to their trading strategy. So they used the auction to reverse this trade, buying the new two-year notes and selling the 30-year bond, which is why it was hammered this afternoon.

So, why is the two-year bond still lower on the day? For one, the equity market rally took some money out of the Treasury market. And despite the reversal in this trading strategy, the broader market still doesn't see a 5.3% yield on two-year notes attractive, especially with the Fed threatening to hike interest rates.

"The curve should stay at a flatter bias, because people are worried about the Fed," said Briggen. "The only reason the two-year note got close to 5.25%

earlier this week was because the emerging markets were falling apart."

The difference in basis points between the two-year and 30-year increased to 48 basis points just after the auction, according to two traders, but had lately retreated to 44 basis points. Selling of two-year notes reflects worry over the Fed's interest rate policy, while the 30-year is sensitive to the prospects of economic growth and inflation.

Tomorrow the

Commerce Department

releases revised first-quarter


figures. GDP grew at a rate of 4.5%, it was reported last month, and expectations are for a decline to 4.3%, according to


. But this report isn't likely to stir much interest. The revision to the

implicit price deflator

, the inflationary component of this report, will probably not be more than a token change. Expectations, according to Reuters, are for no revision to the 1.4% rise in the deflator.