Fear and Selling in Treasuries - TheStreet

Updated from 2:11 p.m. EST

The Treasury market selloff Wednesday shows just how jittery investors are about whether the

Fed

will have to rethink its measured pace of interest rate hikes to keep inflation in check.

Although various bits of inflation-related news triggered initial selling, things really gained steam when the yield on the benchmark 10-year Treasury note broke through 4.40%, a key technical and psychological mark.

Now that the 10-year yield has breached that level, it could navigate a new range for some time. "I think the yield is going to move up from here," said Bill Hornbarger, fixed-income strategist at A.G. Edwards. He believes that over the next several months the yield could break key levels of 4.6% and even 4.88%, which marked last year's high hit in June.

Recently the 10-year note was yielding 4.50%, the highest since July, and down 28/32 in price.

Although Hornbarger said the magnitude of Wednesday's move can largely be attributed to technical factors, the market's uncertainty about the Fed's current pace of tightening underlies everything.

"Right now, the market appears to be more concerned than the Fed is about inflation and commodity prices and oil," he said. "Also the dollar has been weak."

Perhaps with good reason; crude oil futures hit a new record intraday high of $55.70 at midday Wednesday.

Hints about the Fed's latest thinking came from its Beige Book survey of economic conditions released at 2 p.m, EST. The central bank's regional branches saw moderate growth and some price pressures.

"Sustained increases in the cost of energy, steel, and other materials were widespread," the Fed said, adding that manufacturers in some parts of the country were finding it "increasingly easy to pass along price increases."

World of Worry

A confluence of events sparked initial selling Wednesday. They included the German government's report that industrial production jumped a seasonally adjusted 3.1% in January, vs. a much tamer 0.9% increase in December, and comments from European Central Bank President Jean-Claude Trichet, indicating that the bank would begin raising interest rates "if inflation expectations merited action."

Trichet may be worried about the inflationary nature of the surging euro and the slumping dollar, particularly as it relates to the crude oil market, since the commodity is dollar-denominated. The lower the dollar goes, the more likely producers -- such as OPEC -- will want to see prices rise.

In addition, worries about heating oil supplies amid a prolonged bout of unseasonably cold late-winter weather as well as questions about OPEC's production plans ahead of its regular meeting March 16 have stoked prices.

Treasuries were also under pressure because of worries about the outcome of the government's auction of $15 billion in five-year notes today and $9 billion of 10-year notes Thursday, which turned out to be unwarranted. The five-year drew a yield of 4.08%, lower than had been expected. The bid-to-cover ratio was 2.58, a slight improvement from February's auction.

"There were fears this morning of a European rate increase," said Bryan Piskorowski, market analyst with Wachovia Securities. "Also, there's a massive unwinding of five-year and 10-year positions ahead of the Treasury auction over the next two days. I think all that's wrapped together."

The auction was just the latest occasion to worry about demand from overseas buyers, especially central banks. As it turned out, indirect bidders, which include the banks, absorbed 42.9% of the new five-year notes Wednesday, vs. 45.4% at the last auction, and safely above the 40% threshold.

Given the fall in Treasury prices, though, and the corresponding rise in yields, A.G. Edwards' Hornbarger said Wednesday's auction should see good demand.

The Treasury market's activity Wednesday has important ramifications for stocks, said Peter Boockvar, equity strategist with Miller Tabak & Co. "People are underestimating higher interest rates affecting the economy," he said. "Oil is up near $55 and the dollar has been getting slammed ... Rates are reaching high levels while we have markets that are up over their four-year highs. The markets will not be able to sustain these levels in the face of this. Inflation can't be subdued. The potential for disruption in the economy and markets keeps going up."