US Bonds Hold Steady as Investors Test Winds of Economy

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U.S. Treasury yields edged up on Monday to just below their highest levels in eight months as investors got ready for the New Year's first sale of new coupon securities and debated whether the Federal Reserve could end bond purchases before year-end.

Yields moved to eight-month highs last week after minutes from the Fed's December policy meeting caused investors to wonder whether the central bank might end its bond purchases - an unconventional monetary easing strategy - earlier than many had thought.

Though the highest yields in eight months could attract buyers, traders said $66 billion in new coupon-bearing debt supply this week could restrain any significant rallies.

The Treasury is scheduled to sell $32 billion in three-year notes on Tuesday, $21 billion in 10-year notes on Wednesday and $13 billion in 30-year bonds on Thursday. Benchmark Ten-year Treasury notes were last down 1/32 in price to yield 1.91 percent, up from 1.90 percent on Friday. They have risen from 1.70 percent at year-end.

After last week's sell-off, Dan Mulholland, managing director in Treasuries trading at BNY Mellon in New York, sees the notes trading in a range of around 1.85 percent to 2.10 percent.

The dramatic increase in yields so far this year has raised the question of how far the sell-off will go, with debate - again - over whether 2013 will be the year that finally ends the 30-year bond bull run.

Daniel Heckman, senior fixed income strategist at U.S. Bank Wealth Management in Minneapolis, said while the market was wondering about the future of Fed debt purchases, it would also start to realize the comments on that subject in the minutes of a Fed policy meeting were "more in the context of a debate rather than a policy change.

"I'm not saying we'll go to new lows in yields, but we'll get a better tone to the bond market as some of these issues get debated further," he said. An expected political struggle over raising the U.S.debt ceiling could also revive investors' appetite for U.S. debt, viewed as a refuge from financial turbulence.

"The debt ceiling is really going to be a huge battleground for politicians and could cause some temporary pause in the markets where bonds may rally," Heckman said. Even though interest rates have risen sharply since the start of the new year, the retreat in U.S. debt prices may not go much farther he said.

"The Fed is probably not going to end QE in mid-2013," Heckman said, referring to thequantitative easing (QE) the Fed has been doing to try to keep the economy from sliding into a recession, or worse. The Fed wants stronger employment growth before it tapers off, or ends its purchases, he said.

"Another major factor will be consumer behavior; no one has seen the first paycheck of 2013 with the impact of the payroll tax increase," Heckman said. "Once that hits home, it will be interesting to see how consumers react."

Societe Generale sees bond yields marching higher through the year, as economic data continues to improve. "Things are going to get better from here. I think we're already seeing momentum," said Mary Beth Fisher, head of rate strategy at the bank in New York.

SocGen recommends entering trades that would benefit from as steepening yield curve between three-year and 10-year notes to take advantage of an expected increase in volatility.

The Fed will buy debt every day this week as part of its quantitative easing program, meant to hold down long-term borrowing rates in a bid to stimulate the economy. That may help hold down the longest part of the yield curve.

"That may keep a flattening pressure on the market," said Mulholland. "We have a lot of supply this week so I think the rallies will be somewhat capped." The Fed on Monday bought $1.47 billion in bonds due from 2036 to 2042.

The Treasury will sell $32 billion in three-year notes on Tuesday, $21 billion in 10-year notes on Wednesday and $13 billion in 30-year bonds on Thursday.