What’s bad for Uncle is good for many of his constituents

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The Treasury is having a harder time selling its debt -- just as it has a lot more to sell, as the federal deficit widens.

Uncle Sam’s auction of $19 billion in five-year notes on Thursday attracted the weakest demand since 2003.

After giving a relatively healthy reception to the Treasury’s record sale of $30 billion in two-year notes on Wednesday, investors fell back into their pattern of the last five weeks -- which has been to dump government bonds in favor of other securities.

That pattern is continuing today. The five-year T-note yield is up to 3.18% in midday trading, compared with 2.9% a week ago and its recent low of 2.2% on March 17.

Part of what’s going on is a market reassessment of how many more cuts the Federal Reserve is likely to make in its benchmark short-term rate. Fed policymakers are expected to shave their rate to 2% from 2.25% when they meet next week. But they could signal at that point a desire to pause for a while, given food and energy inflation pressures.

Another market shift pushing Treasury yields higher is a lessening of investors’ fear level about the economy and the financial system, after the panic of last month.

Even today -- with oil back above $118 a barrel on renewed U.S.-Iran tensions, and a new report showing U.S. consumer confidence at a 26-year low -- investors aren’t running back to Treasuries for a haven. That says something.

What’s bad for Uncle Sam’s debt costs, meanwhile, has been good for the stock market and for corporate bonds, as investors have become less risk-averse. Stocks have rallied since mid-March. And the average yield on an index of 100 junk bonds tracked by KDP Investment Advisors fell to 9.26% on Thursday, down from 9.50% a week earlier and down from the recent peak of 10.16% in mid-March.

Still, there are plenty of people on Wall Street who think the market is wrong to believe the Fed will stop at 2%. This camp sees the economy getting substantially worse, forcing the Fed to ease credit further -- and sparking renewed investor demand for Treasuries as a good place to hide.

Yields on government bonds have jumped, but ‘people are confusing a change in prices with a change in facts,’ says David Ader, government bond strategist at RBS Greenwich Capital Markets in Greenwich, Conn.

‘There has been nothing to suggest things are turning around in the economy,’ he says.

Posted April 25, 2008