With a burgeoning war bill to pay and the bond market in a free fall, this week's Treasury auction is shaping up to be a big one, with implications extending beyond fixed-income desks.

So far, things are looking surprisingly good.

In the first leg of the three-day quarterly refunding, the Treasury sold $24 billion of new three-year notes into brisk demand that was boosted by still-flush foreign governments. The auction's stopout yield -- essentially the lowest successful bid -- was 3.19%, about a basis point better than expected.

Meanwhile, the auction's bid-to-cover ratio, which compares the number of bids with the amount of securities sold, was 2.08. That compares with 2.27 in February, but is still considered fairly robust demand. Of course, recent concerns about a

Fed

tightening meant the bonds sold at a much weaker price than three months ago, when the stopout yield was 2.33%.

"The three-year is a good place to be with a Fed hike coming up, so today's solid auction results make sense," says Paul Mendelsohn, strategist at Windham Financial. "The big question mark is Thursday's 10-year auction, which comes after a PPI report that could show some serious higher prices for food and gasoline."

The 10-year note was recently trading up 5/32 to yield 4.77%.

A closely watched number in this quarter's auction is the percentage of so-called "indirect bidders." The share, which includes foreign central banks and is a rough way of gauging overseas demand for U.S. assets, came to 45.6% in Tuesday bidding. That's down from 46.8% last quarter, but still shows that central banks in countries like Japan and China crave a parking place for dollars, something the Treasury is counting on to keep the federal deficit funded.

Coming into the auction, government figures showed the Bank of Japan had about $180 billion it needed to invest, a larger-than-normal hoard that reflected its efforts to stem the yen's appreciation in the first quarter. Japan is the largest foreign holder of U.S. debt with $607.9 billion at the end of February, followed by China, which held $145 billion.

Part of the reason for Tuesday's demand was a relative shortage of Treasuries on world markets, said Bob Gay, global strategist at Commerzbank.

"When you are trying to control your currency you don't care where you buy Treasuries -- they just wanted the quantity," Gay said. "But with deflation over in Asia, and a weak yen as of late, they no longer need to buy so much to support their currencies."

Andy Harding, director of fixed income at National City, said he was expecting a normal refunding this week with demand across the spectrum.

"If the Japanese take the three-years and the rest of the buyers take the rest, it will be OK," says Harding.

The refunding continues Wednesday with $15 billion in new five-years being auctioned, followed by $15 billion in new 10-year notes on Thursday.