Amid signs that the U.S. economy continues to navigate a steady growth path, the August refunding will be a litmus test of investor attitures and the bond market's appetite for new government supply.
Treasury market participants are anxious to get a read on investor demand for fixed-income securities. Interest rates, they argue, have backed up significantly in recent sessions and have presented investors with attractive yield levels. Furthermore, many market observers are stoic in their belief that economic growth will slow in the second half of the year.
However, the outlook for the auctions has been clouded by the increasing likelihood that the Federal Reserve will raise short-term interest rates next week. Throwing further uncertainty into the mix are a number of crucial economic reports due out this week, including the July producer and consumer price reports and July retail sales. "Supply is a significant hurdle this week, and one that will give the market an indication of how retail accounts feel about putting money to work," said Anthony Karydakis, senior financial economist at First Chicago Capital Markets Inc. "All eyes are on the auctions."
Convincing retail accounts to buy Treasuries amid signs of continued growth in the economy will be no small feat, analysts agree. Standing in the way of stepped-up demand for government-backed paper is the Fed, which many observers see as on the verge tightening monetary policy. Against that backdrop, market analysts expect a concerted effort by the primary dealers to build a concession into the market to gain the interest of retail accounts.
While some fixed-income observers believe Friday's steep sell-off may have backed yields up enough to ensure buying interest at the refunding, most think that demand will be hampered by uncertainty over what the Fed will do.
"The outlook for this refunding is not great," said Michael Niemira, a money marked economist at Mitsubishi Bank Ltd. "As has happened in prior refundings, the employment report has set the tone, and the tone is negative after the [long] bond fell two points on Friday."
The Treasury Department is scheduled to sell $40 billion of notes and bonds this week to raise about $10.4 billion in new cash and redeem $29.6 billion of securities maturing Aug. 16. The August refunding package will consist of $17 billion of three-year notes to be auctioned today, $12 billion of 10-year notes to be sold tomorrow, and $11 billion of 30 1/4-year bonds to be auctioned Thursday.
Cary Leahey, senior economist at Lehman Government Securities Inc., said many accounts will probably avoid bidding aggressively at the auctions in hopes of buying the issues cheaper once the central bank tightens. "The market has shifted from having an optimistic view of the Fed to expecting a tightening on Aug. 16," he said. Against that backdrop, "I don't expect to see particularly good demand for new securities," Leahey said.
Like most market observers, Leahey thinks the 10-year note will be the toughest sell this week, particularly because it will be sold on the eve of potentially market-moving economic figures and one week before many expect the central bank to tighten.
The three-year note, on the other hand, should benefit the most from the recent backup in rates and the abundance of short positions that have been established in anticipation of further price declines ahead of the auctions, observers said.
The 30-year bond is the wild card of the August refunding, analysts said. The long bond is widely thought to be the issue that has the most to gain from another tightening of monetary policy. Scarcity value is likely to be another boon for the 30-year issue, given that the maturity is now sold only twice a year.
Some market analysts expressed the view that the when-issued long bond could benefit from its 30 1/4-year maturity. The Treasury chose that maturity to give zero-coupon dealers more choices of bonds to strip and to further increase supply by possibly reopening the bonds when the Treasury sells 30-years again in February 1995.
Yesterday, Treasury market prices ended mixed with the long end garnering support from the stronger U.S. dollar and the short end lagging somewhat ahead of this week's refunding auctions.
The 30-year bond ended up 2/32 to yield 7.53%, while the two-year note closed unchanged at a yield of 6.20%.
The dollar posted gains against the Japanese yen yesterday after breaking above a key technical resistance level in overseas trading. The greenback changed hands late Monday at 101.50 yen compared with 100.28 late Friday.
Long-term bond investors were heartened by the dollar's better performance yesterday and pushed prices slightly higher, as a stronger U.S. currency generally helps alleviate some of the inflation threat.
The short and intermediate sectors of the yield curve took the brunt of selling as dealers prepared for the deluge of new government debt.
"Buyers kept their distance from the shorter and intermediate securities, which left little more than sellers in a thin market," a note trader said.
Avoidance of short-dated Treasuries comes amid signs that the U.S. economy continues to grow apace and that the central bank will tighten monetary policy sooner than later. Higher rates have made short-term governments considerably less attractive in recent sessions and virtually ensured a weak performance by the short end this week.
Near term, the state of affairs at the long end of the maturity spectrum probably won't be much better. Evidence of economic expansion and higher wage pressures do not bode well for Treasuries in the intermediate and long sectors of the market. Still, losses at the long end are unlikely to be as deep because investors believe that stretch of the yield curve has the most to gain from tighter credit in the long ran.
Selling emerged late last week as bond investors' worst fears were validated by the July employment report, which showed the economy is not slowing in the third quarter.
News of a gain of 259,000 jobs in July nonfarm payrolls discouraged market players who had been looking for the report to support the view that the economy is slowing. Market observers had predicted that Treasuries would sell off with an above-200,000 gain in nonfarm jobs.
In recent weeks, the market has improved amid signs of slower growth in the economy and moderation in consumer spending patterns. That notion was supported by GDP growth in the second quarter that suggested softer economic fun-damentals. But the July employment report probably returned the Fed to its original course of raising interest rates, analysts said.
In the secondary market for corporate securities yesterday, spreads of investment-grade issues held mostly steady, while high-yield bonds generally improved by 1/8 of a point.
In the futures market, the September bond contract ended down 6/32 at 104.19. Treasury Market Yields Prev. Prev. Monday Week Month 3-Month Bill 4.57 4.36 4.53 6-Month Bill 5.09 4.84 5.03 1-Year Bill 5.57 5.34 5.57 2-Year Note 6.20 5.99 6.25 3-Year Note 6.49 6.24 6.58 5-Year Note 6.93 6.71 7.07 7-Year Note 7.07 6.87 7.27 10-Year Note 7.27 7.09 7.45 30-Year Bond 7.53 7.38 7.71 Source: Cantor, Fitzgerald/Telerate