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Treasury's Auction of 7-Year Notes Is Better Than Expected

The bond market got a bit of relief Thursday, as a $28 billion auction of seven-year notes went somewhat better than expected.

AP

The auction saw a yield of 3.369 percent on a bid-to-cover ratio of 2.63 as the price tag continues to increase for the government's massive debtload.

The bond market this week already has weathered two tepid auctions, for two- and five-year notes. With today's auction of $28 billion in seven-year notes sending investors even further out on the yield curve, there was little optimism that things would change.

"As an investor you've always got to look at how much debt is too much debt," says Bill Walsh, president of Hennion & Walsh in Parsippany, N.J. "It's a lot of supply for the market to absorb. The actual buyers, the investors, are questioning at what rate should we be buying this stuff."

Wednesday's weak 5-year auction of $39 billion followed a poor 2-year auction of $42 billion earlier in the week, sparking concerns over how much it will cost to fund more than $2 trillion in government debt related to corporate bailouts and stimulus programs.

At stake is the pace of economic recovery.

Just as more signs continue to pop up that the economy is coming back—housing sales and prices are finally showing signs of a bottom while the trend of unemployment seems to be downward—high Treasury yields stands as an ominous burden for the country to bear.

"Background pressures that we've seen building in the Treasury market are starting to spill over," says Mike Larson, analyst at Weiss Research. "Creditors have made a lot of noise how they want to direct less money to US shores. Now here we are right back in the soup again with a very crummy five-year auction yesterday."

Analysts have been looking at bond weakness as displayed in low bid-to-cover ratios, an expression of the number of bids received to those accepted. A low number is indicative of weak demand.

The two-year auction saw a bid-to-cover of 2.75, while the five-year was at 1.92, both below the recent norms, making the seven-year note a break from the trend.

When bidders are relatively scarce the bonds go at lower prices and higher yields, meaning greater expense for the government in paying off the investors picking up the tab for all the deficit spending.

For the economy, that translates into potentially higher interest rates and obstacles to recovery, particularly in the form of housing loans. The Fed has been trying to keep home lending cheap by buying mortgage-backed securities, but could be faced with a dilemma if rates start rising.

"As interest rates go up it's going to be a factor that keeps the recovery even more sluggish than it would be otherwise," Larson says. "It's one of the things that will temper the rebound in interest-sensitive sectors."

So far, though, the damage done to Treasurys has been mostly limited to the bond trade, though a prolonged trend of weak auctions could shake investor confidence on the equity side.

China is the biggest buyer of Treasurys, and investors will be watching to make sure that foreign governments, particularly central banks, continue to show interest in US assets. Should confidence begin to falter, that could eventually cause contagion in stocks.

"Since the auctions have been substantial, you will see equity buyers want to see how that is doing. Did it push yields up? Are the buyers coming in?" says Quincy Krosby, general market strategist at Prudential Financial. "It's probably prudent at this level for investors to watch these signals in the market."