Last updated: February 5, 2009 8:28 pm

Avalanche of Treasury bonds raises new fears

Treasury refund packages

These are busy times for bond traders as the number and size of US Treasury auctions keeps growing in order to fund the federal government’s spending spree.

This week, the US Treasury told traders it was bringing back the seven-year note, which was last seen in 1993.

While its return was not a surprise, the Treasury shocked the market with the news that the note would be sold every month.

This comes after the Treasury late last year reintroduced monthly sales of three-year notes, which were halted in 2007.

Rick Klingman, managing director of BNP Paribas, said: “It’s pretty alarming that two issues have returned and are being issued monthly rather than just quarterly.”

Another sign that plugging the budget deficit looks tough was the Treasury’s announcement that it might start selling 30-year bonds every month, with a decision coming in May.

That raises the prospect that every benchmark Treasury issue will be sold every month later this year.

William O’Donnell, strategist at UBS, said: “It would be unprecedented to see every Treasury security sold each month. We expect $1,900bn in net borrowing for this financial year and this is the only way the Treasury can get there.”

This avalanche of supply comes at a time when more than half of the current $5,500bn Treasury market is held by foreign investors. With big holders of Treasuries such as China and Japan facing tough economic times at home, bond dealers worry that they may be left holding plenty of Treasuries at auctions should foreign support dry up.

“There is a lot of concern about who will be there at the end of the day to buy all this debt”, said Tom di Galoma, head of Treasury trading at Jefferies & Co.

Higher bond yields mitigate the efforts of the Federal Reserve in trying to bring down 30-year mortgage rates, which track the risk-free rate of long-term Treasury yields.

Since the end of December, the yield on the 10-year note has climbed from 2.08 per cent to a high of 2.95 per cent this week, pushing mortgage rates higher.

Traders believe a further rise in long-term yields could compel the Federal Reserve to fulfil its recent statement that it “is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets”.

On Thursday, the 10-year note was yielding 2.92 per cent and a dire January jobs number – the data are due out today – could pull yields lower.

Such a move may only be temporary as dealers are likely to start selling Treasuries in order to make room for next week’s record $67bn package of new three-, 10-, and 30-year securities.

Mr Klingman says yields may keep rising after the refunding and he thinks that the Fed could decide to stop 10-year yields breaking above 3.25 per cent.

“It’s the last option for the Fed but they could come in and send a signal to the market,” said Mr Klingman.

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