US debt drives bond rout

US government bonds came under heavy pressure again as investors worried about the ever-expanding amount of debt needed to fund a record US$1.75 trillion budget deficit.

The downdraft in bonds was so heavy it actually dragged down the U.S. stock market, inverting the more normal relationship where Treasuries tend to track equities.

Selling by mortgage investors, who are often forced to sell U.S. Treasuries to hedge their positions, when yields surpass key levels, added renewed impetus to the downturn.

The decline was largely concentrated in longer-dated maturities, driving the gap between short- and long-term rates, known as the yield curve, to its steepest level on record.

"The market is just in bad shape," said Lou Brien, market strategist with DRW Trading Group in Chicago.

Benchmark 10-year notes were down over 1-16/32 and yielding 3.74 percent, up nearly 20 basis points in just one day and over 1.25 percentage points in just six weeks. The spread between 10- and two-year notes widened to 275 basis points, the largest ever gap.

The market has become increasingly bearish since mid-March, when the Federal Reserve first announced its intention to buy up to $300 billion of U.S. Treasuries over six months.

The rise in yields in recent weeks was at first due to signs of economic stabilization and less need for a safe-haven, but recently the trend has shifted toward skittishness over the huge U.S. government borrowing requirement this year.

The Fed bought $6 billion in Treasuries on Wednesday alone, but that was not nearly enough to stem the tide.

Mortgage servicers often sell Treasuries to hedge against the unwanted lengthening of their portfolio's duration as yields head higher and curtail home loan refinancing activity.

NOT ENOUGH

Wednesday's auction of $35 billion in new five-year Treasury notes actually found good demand, particularly from indirect bidders, who took 44 percent of the deal. That category is often used as a loose proxy for foreign central bank interest in Treasuries, so traders welcomed their showing.

However, there were lingering fears about the broader picture. With $2 trillion or more in net issuance seen coming to market this year alone, some dealers were looking for a sharp readjustment in bond yields to reflect the cost to government of financing its borrowing.

With another auction still to go this week in Thursday's sale of $26 billion in seven-year Treasury notes, traders felt it was too early to breathe a sigh of relief, particularly with market sentiment being so negative. Seven years are a relatively new maturity, which means that dealers are still unfamiliar with patterns of investor interest, especially from foreigners.

As the selling deepened, the 30-year Treasury bond fell over two full points, pushing its yields 14 basis points higher to 4.64 percent.

"Now yields are rising to levels that are becoming very worrisome for the economic outlook," said William Sullivan, chief economist at JVB Financial Group in Boca Raton, Florida.

- Reuters