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Bond traders haven't been so leery of auctions since the crisis

Bloomberg logoBloomberg 3/12/2018 Brian Chappatta

Add one more thing to the list of worries for the world’s most indebted nation: weakening demand at its bond auctions.

While there’s no danger of the U.S. being unable to borrow as much as it needs, over the past two years, the drop-off has been unmistakable. Based on the number of bids that investors submitted versus the amount sold, average demand for 10-year notes has fallen to the lowest since October 2009.

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Now for bond traders, there’s little in the data to suggest that weak auctions lead to losses in Treasuries, but it’s an early sign some investors are backing away from funding America’s obligations as U.S. budget deficits balloon and the Federal Reserve is raising interest rates. It’s a potentially toxic mix that could erode demand even more in the months ahead.

“There’s no good playbook, unfortunately,” said Thomas Simons, a money-market economist at Jefferies. “Treasury supply is further exacerbating what should be a natural move away from the market” as interest rates climb.

The yield on benchmark 10-year Treasuries has already risen around half a percentage point this year and was at 2.89 percent as of 7:30 a.m. Thursday in New York.

The government’s financing needs have already started to grow. As a result of the Trump administration’s tax cuts, the deficit is set to widen and reach almost $1 trillion next fiscal year. The shortfall is on top of the almost $21 trillion of debt the U.S. already owes, more than any other country. (Roughly 70 percent of that total is in the form of Treasuries.)

Excluding short-term bills, the U.S. government plans to borrow $62 billion at debt auctions this week by offering Treasuries due in 3, 10 and 30 years. The total is about $6 billion more than auctions of the same maturities in January. The first batch of enlarged sales last month were “noticeably worse” by most measures, Simons said.

Economists have questioned the value of Trump’s debt-financed tax cuts this far into the post-crisis economic cycle, in part because the stimulus is a departure from prevailing theory and the norm in recent decades. Borrowing has tended to decrease when the Fed is raising rates, and vice versa.

And with Fed officials projecting three rate increases this year, the opposite is poised to happen in 2018.

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In the past two years, the average bid-to-cover ratio for 10-year note auctions has fallen to 2.46, the lowest since the period encompassing the financial crisis. As recently as 2013, the two-year average was above 3.

The current level is still a long way from falling below 1, which would mark a failed auction, and no sale since at least 1983 has come closer than 1.22, a low mark set in October 2008 and May 2003. While nobody expects demand to test that level any time soon, the recent drop-off has raised plenty of eyebrows.

“The market is going to need a bit of time to adjust to sizes going up,” said Aaron Kohli, director of fixed-income strategy at BMO Capital Markets. “When bid-to-covers were high and rising, it was when the Fed’s buying was driving yields lower. If the Fed is on the warpath, Treasuries aren’t the best thing to hold, and certainly your demand is going to take a hit.”

Post-crisis financial regulations have made it more costly for primary bond dealers, which are obligated to bid at auctions, to soak up the additional Treasury supply. And to Kohli, there’s only one foolproof way to attract more bidders: higher yields.

But for bond traders, the day-to-day implications are less clear. Take last month’s 10-year auction. Demand was the ninth-lowest since the start of 2009. In all the instances it was lower, yields fell four times and rose four times in the following month. Sometimes, Treasuries rallied into the offering; on other occasions, they were in the midst of a selloff.

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Grand Conclusions

That’s why some strategists are reluctant to draw any grand conclusions from the upcoming slate of auctions, particularly as investors try to assess the fallout from the latest round of tariffs imposed by President Donald Trump.

“The auction stats that come out immediately after auctions are really a referendum on how well the market is pricing in the risk and the concession built in,” said Blake Gwinn, strategist at NatWest Markets. “As far as the longer-term trend in yields, can you look at a strong auction and say clearly we’re in a bullish market? I don’t know I’d ever really go that far.”

Auction demand, of course, may change from one month to the next, but the two-year trend paints a clearer picture. For three-year notes, the average bid-to-cover ratio is close to the lowest since July 2010, while for the 30-year bond, it’s hovering around its post-crisis lows.

As supply increases and Fed rate hikes build up, it’s only a matter of time before the burgeoning debt load starts to weigh on bond investors.

“This supply issue is going to cause a lot of pressure on the market,” said Simons. “It’s just taking some time for that effect to be built into people’s expectations, because we’ve only had one month of the larger auction sizes.”

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