Thursday, March 25, 2010

Treasurys Sink After Poor Sale

NEW YORK—Treasury prices fell hard after a poor five-year auction that escalated concerns about the government's ability to sell its massive amounts of debt.

Worries about supply picked up this week after the government's $44 billion two-year auction on Tuesday attracted less demand than anticipated. The five year sale was messier, sending Treasury prices tumbling. Demand at the auctions may have been impacted by less buying from Japan as its fiscal year-end approaches. Nonetheless, the poor results put investors on edge given the huge amounts of debt the government is likely to continue to issue to fund its budget deficit.

Investors were reminded of the huge amounts of debt the government will need to continue to sell after President Barack Obama signed into law a $940 billion health-care overhaul bill on Tuesday, which will necessitate even more borrowing by the government.

"We're going to continue to see massive amounts of supply in Treasury-land," said Brian Edmonds, head of interest rates at Cantor Fitzgerald & Co. in New York.

Also driving government bond prices lower was selling from investors looking for higher yields in the current low-interest rate environment. Market participants have taken to heart Federal Reserve reassurances that interest rates will remain low for a while, shedding Treasury securities and heading into higher yielding securities in an effort to get better returns.

Corporate issuance has been robust lately. On Wednesday at least $20 billion was expected to be sold in the U.S. and Europe, including an offering from California of 30-year bonds that could yield above 7%, much higher than the 4.709% rate on the 30-year Treasury.

In afternoon trading, the two-year note was off by 5/32 to yield 1.099% and the 10-year note was down by 1 8/32 to yield 3.831%. The 30-year was down by 1 30/32 to yield 4.719%.

Miller Tabak chief economic strategist Dan Greenhaus noted that the 10-year Treasury yield has solidly pushed through the 3.77% level that the market was watching quite closely.

Treasury prices Wednesday were being knocked lower as well by a move in the interest-rates swaps market that highlighted concerns about supply. In that market, investors exchange fixed-interest payments for floating payments. Spreads, the rate premium of swap rates over Treasury yields, tightened more Wednesday, with the 10-year swaps spread pushing deeper into negative territory after falling there Tuesday for the first time, and the seven-year spread turning negative.

The move in swaps implies investors see more risk in holding triple-A-rated 10-year Treasury notes than in swapping rate payments with private counterparties. Spreads have tightened as Treasury supply remains robust and because more corporate issuance has resulted in greater hedging needs in the market. In afternoon trading, the 10-year swap spread was at -9.25 basis points after tightening to -2.5 basis points Tuesday afternoon. The seven-year was at -1 basis point.

"You get this snowball effect," said Larry Milstein, head of government trading at R.W. Pressprich & Co. "It's all of these things working together, and everybody going out the door at the same time. Then you hit certain levels and it feeds on itself."

Auction results showed that the government had to pay up to find homes for the new five-year notes. They were sold to yield 2.605%, higher than the 2.569% yield just before the 1 p.m. EDT auction deadline. The sale was more than two times oversubscribed by investors, with a bid-to-cover ratio of 2.55. That was below the average 2.74 bid to cover ratio from the past four five-year auctions.

The indirect bid, considered a proxy for demand from foreign buyers including central banks, came in at 40%, compared with 40.3% in February and 53% in January. The direct bid, a category of bids from nonprimary dealers, banks, money managers and depository institutions that have direct accounts to submit bids to the Treasury auctions, was 11%, compared to 12.8% in February and 7.4% in January.

It was an "ugly auction," said Ward McCarthy, managing director of the fixed-income division at Jefferies & Co. "You're starting to see a bit of a Treasury market protest. There's a very legitimate concern that Washington is pushing the envelope too far in terms of the U.S.'s ability to carry all this debt."

Results follow a weaker-than-expected two-year auction on Tuesday and come ahead of the government's final note sale of the week Thursday, a $32 billion sale of seven-year notes.

Mr. Milstein said sometimes two poor auctions are a good backdrop for the third sale of the week. The seven-year Treasury was also lagging other maturities late Wednesday as investors attempted to cheapen up the issue before the sale. The risk, though, remains that the seven-year auction could also be weak.

Meanwhile, agency mortgages got hit Wednesday by a combination of weaker Treasurys performance and stronger swaps spreads. This led to better selling in the lower coupons, which led to widening of risk premiums by three basis points to 131 basis points over comparable Treasury yields.

—Prabha Natarajan contributed to this article.

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