Thursday, June 4, 2009

Higher rates is going to dry out 'green shoots'

The U.S. government's need to borrow more than $2 trillion this year to help fund its projected $1.8 trillion deficit and revive ecomomic growth will again test investors' appetite for U.S. Treasury debt next week.

A total of $65 bln in 3-year, 10-year, and 30-year debt will be sold next week, the U.S. Treasury said on Thursday.

The sales will consist of $35 billion in three-year notes, $19 billion in 10-year notes, and $11 billion in 30-year bonds.

While next week's offering is smaller than last week's record $101 billion sale of two-, five- and seven-year notes, yields on all but the shortest Treasury maturities have recently risen to their highest levels in six months at least party because of the extra supply.

"All of these auctions are tests for the market," said Ward McCarthy, managing director and economist at Stone & McCarthy Research Associates in Princeton, New Jersey.

"It's like incoming artillery. As to whether or not the markets can handle all this stuff, the answer is 'Yes, they can handle it, but only if there are higher yields to make these issues more attractive.'"

Investors are also seeing in recent economic data the first signs that the recession may be bottoming out, meaning less need for the safe-haven of government bonds and more appetite for riskier bets on stocks.

"Confidence is returning to other markets and fears of deflation have given way to fears of inflation," McCarthy said. "This creates a toxic brew for the Treasury market."

Another issue that has worried the market is whether the huge amount of U.S. debt sales would repel some of the country's key sovereign creditors, in particular China.

But the most recent Federal Reserve data has shown that overseas central banks continue to increase their holdings of U.S. Treasuries, even after Standard & Poor's warning on Britain's AAA rating sparked concern the U.S. economy might be headed for a similar fate.

Thomas Higgins, chief economist at Payden & Rygel Investment Management in Los Angeles, said the market had a "completely preverse" near-term preoccupation with supply.
"In three months, economic data will matter a whole lot more to the market than supply, but right now the market is focused on supply and what it perceives as inflation," said

"Supply only matters in the very long-term, but the market is viewing it as a very near-term issue, Higgins said.

"In a recession, demand is falling so prices fall and you typically see lower bond yields," he said. "But right now you're seeing bond yields rise and no one thinks they will stop rising after the next week's auctions."

What will reverse the global rise in government bond yields will be the softer economic data that will come about as a result of those higher interest rates, Higgins said.

"The first place you will see that show up is in housing and we're already seeing that in the latest re-fi numbers which showed that mortgage refinancing applications were down 16 percent week in the latest week and were down 14 percent the week before," he said.

If yields stay high enough long enough to threaten a still very nascent - perhaps even theoretical - economic recovery, that could intensify discussion about further Federal Reserve purchases of government, agency and mortgage bonds.