US Bond Prices Gain After Solid TIPS Auction

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U.S. Treasury debt prices rose on Thursday after the Treasury saw solid demand for new inflation-linked bonds, though benchmark yields held above 2 percent as traders worried about how high yields might rise whenever the U.S. Federal Reserve decides to taper its bond purchases.

The bond market was on another rollercoaster ride on heavy volume, a day after remarks by Federal Reserve Chairman Ben Bernanke about the U.S. central bank's bond purchase program prompted a massive selloff in Treasuries.

Bernanke told a congressional panel that a decision on whether to scale back the Fed's current monthly pace of $85 billion in purchases of Treasurys and mortgage-backed securities could come at one of the Fed's "next few meetings" if data shows the economy is gathering steam.

Traders fear that any reduction in the bond purchases would mean less cash to fuel the stock rally that has driven major Wall Street indexes to all-time highs. A reduction in the bond-buying program would also send Treasury yields higher.

"It was a trial balloon from Bernanke. The market reacted poorly," said Thomas Roth, executive director of U.S. government bond trading at Mitsubishi UFJ Securities USA in New York.

Benchmark 10-year notes at times struggled to recover after suffering their biggest one-day yield jump since September. Prices rallied after the TIPS action, with 10-year notes last trading up 6/32 in price, with yields holding above the key 2 percent level, at 2.03 percent. The 30-year bond rose 16/32 in price for a yield of 3.20 percent.

The Treasury saw solid demand for its $13 billion reopening of 10-year Treasury Inflation-Protected Securities (TIPS), despite the volatility.

So-called indirect bidders, which typically includes fund managers and other end users, bought 56.8 percent of the bonds, the highest level since November 2010, while dealers took only 30.90 percent, the lowest on record for the auction.

The new notes yielded around 2 basis points more than where they traded before the sale, at minus 22.5 basis points.

"Overall it's a positive sign of demand given how much uncertainty there was going in. Perhaps the TIPS market has gotten cheap enough to provide value once again," said Michael Pond, head of global inflation-linked research at Barclays in New York.

Inflation expectations have fallen since mid-March as energy prices drop and as some investors worry that the Fed will lose a battle to stimulate inflation to grow the economy.

Increasing speculation that the Fed may be close to reducing the scale of its bond purchases may add to a drop in inflation expectations if traders believe that the U.S. central bank will reduce stimulus even as economic growth remains tepid.

If the Fed is seen as only pulling back on stronger growth, on the other hand, inflation products should not be negatively affected, said Pond.

"We think the Fed would taper because it saw a significant strengthening of the outlook of the labor market, so we think forward breakevens should remain stable," he said.

Market inflation expectations as measured by forward contracts that show where traders think inflation will be in five years' time, a closely watched indicator by the Fed, have fallen to around 2.70 percent from 2.89 percent in mid-March, though they remain in their recent range of around 2.62 percent to 2.89 percent where they have traded since last September.

Heavy Volumes

Bernanke's comments on Wednesday brought the bond market back to life as investors reevaluated where yields would be without the Fed buying. Volumes have in general been subsiding as a result of the lower volatility from the Fed's bond purchase program.

(Read More: Aiming for Nuance, Bernanke Does Rhetorical Figure Eights)

Volumes stayed high on Thursday, after Wednesday's trading session saw the heaviest volume in over five years, with over $600 billion in bonds changing hands in U.S. trading.

In the futures market, 2.3 million contracts of the June 10-year T-note futures changed hands in trading through 3 pm EDT on Thursday. On Wednesday, 2.9 million on this bond contract traded, which was the most in a single day for a front-month 10-year T-note contract since early 2008.

The Fed bought $3.65 billion in notes due 2019 and 2020 on Thursday as part of its ongoing purchases.

It will not buy any bonds on Friday, when the bond market is due to close early at 2 p.m. EDT for the U.S. Memorial Day holiday.