Smooth Treasury Auctions May Fade in 2010

The Treasury market absorbed $118 billion in notes this week without a hitch but next year, markets may not be so nice as investors worry about inflation and the growing supply of new issuance.

Treasury Building
Treasury Building

Traders had been watching this past week's auctions with some trepidation because it is an unusual time of year for the Treasury to conduct auctions. There are fewer investors around and foreign buyers are conspicuously absent. Yet, the auction of 2-year, 5-year and 7-year notes found plenty of buyers. Wednesday's auction of $32 billion in 7-years was well received with yields close to expectations and bids worth 2.72 percent the auction amount, despite the lack of foreign interest.

Some market strategists have been warning investors away from Treasurys in the year ahead, saying a rate rise could burn them. The views from the Treasury market though are diverse, with some strategists say things may not be that much different in 2010, while others see a sizeable jump in rates. Many strategists expect the 10-year to surpass 4 percent and some even see 5.5 percent in 2010.

"Everybody expects a major steepening of the yield curve, but I think we're already there," said George Goncalves, Treasury strategist at Cantor Fitzgerald. "We'll have a period of higher rates but not as much as people are calling for."

"I do believe short-term notes and short-term rates are going to get hurt badly. I don't think it's going be the back end," he said, noting a view on the street is that the longer duration bonds will be the ones investors shun. For the 10-year, he expects to see rates rise to 4.25 percent, with an outside shot at 4.50 percent.

Rates have moved higher during December. The 10-year was just above 3.2 percent in late November, and it has moved near 3.8 percent. Goncalves said one reason rates have been moving higher in December has more to do with investors having closed out their books and not participating in the market temporarily.

A major factor for the Treasury market is how well it can conduct auctions of the hundreds of billions needed each month to fund the deficit. The success of the auctions depends on the participation of those foreign banks and governments. The other lever will be the timing of the Fed's move away from its zero interest rate policy, not expected until mid year at the earliest and not until 2011 by many.

Ian Lyngen, senior Treasury strategist at CRT Capital, said he expects rates on the 10-year to stay in a range of 3.25 to 4.25 percent in 2010. "That will probably account for 80 percent of the year's trading activity. We might go above there but it will be short lived," he said.

Lyngen, however, believes the yield curve could flatten as the year goes on, meaning the yields on long and short term securities will narrow.

"We will have record growth in issuance for sure...but some of the shock and awe might be mitigated by the fact that the auction sizes and frequency are going to become routine. Still, the Treasury runs the risk of saturation," he said.

Lyngen said one factor helping bonds in the new year is the amount of Treasurys being purchased by banks. "We are shifting from a nation of net spenders to net savers and that money's going into banks and banks are increasing their net holdings of Treasurys," he said.

At the same time, banks have curbed lending and are hoarding a huge amount of Treasurys as newly built reserves.

"We think rates are going to have upwards pressure in the first quarter of next year, but when economic data doesn't end up decisively strong in the balance of the first quarter, we're going to see the strength of the economic recovery challenged," he said. Lyngen said he then expects the yield to flatten out toward the end of the year when the Fed does start to move toward higher rates.

Goncalves said another factor may be that the economic recovery gains traction, and that would reduce the amount of stimulus spending needed. "It's not something to be cheering from the sidelines. A rising rate and a nation that is highly indebted...I think that if anything, if we were to push the upper boundaries, it would cause enough pain in other markets that it would cause people to choose our debt."

Lyngen also said another wild card for markets, which could be supportive for bond prices, is geopolitical uncertainty. Markets were reminded of this in the past week when a Nigerian bound for Detroit attempted to blow up a plane. Iran's nuclear ambitions are also a potential factor for markets.

Questions? Comments? Email us at marketinsider@cnbc.com