Bond investors show who’s boss on long-term rates

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It’s a rough day for the bond market, and that has helped drag the stock market down after an early rally.

In Britain, the government failed to find enough buyers for an offering of $2.55 billion in 40-year bonds.

In the U.S., the Treasury’s auction of $34 billion in five-year notes drew weaker-than-expected demand, driving the yield up to 1.85%, compared with the 1.80% that many traders had anticipated.

Britain, the U.S. and many other countries are borrowing heavily to try and spend their economies out of recession. Those spending plans depend on investors’ willingness to keep buying government bonds, and at low interest rates.

Even with the Bank of England and the Federal Reserve each pledging to buy some of their own government’s bonds as a show of support, the bond markets are demonstrating today that investors call the shots on the direction of long-term interest rates.

In Britain, investors placed orders for about 93% of the bonds in today’s sale, according to Bloomberg News. It marked the first time in almost seven years that a sale failed to draw enough demand to complete the deal in full.

‘This is a warning signal investors are sending to the government,’ Neil Mackinnon, chief economist at hedge fund ECU Group in London, told Bloomberg. ‘Investors are giving the thumbs down to the gilt market.’

But a spokesman for Prime Minister Gordon Brown asserted that ‘the underlying strength of the market in gilts is there, reflected by the fact that our yields remain low. The shortfall in funding today can be made good in future auctions.’ British bond yields initially rose on news of the sale today, but then came back down.

The U.S. Treasury sale of five-year notes attracted plenty of bids -- $69 billion for the $34 billion in notes offered -- but the higher-than-expected yield that investors demanded has spooked the Treasury market overall.

The 10-year T-note yield was at 2.76% about 12:15 p.m. PDT, up from 2.65% on Tuesday -- even though the Federal Reserve today began buying Treasuries for its own account, as promised a week ago.

On Wall Street, interest-rate worries have helped turn a 204-point rally in the Dow Jones industrial average into a 57-point loss with about 45 minutes of trading to go.

-- Tom Petruno