Treasuries Fall as Demand at Two-Year Note Auction Declines

Treasuries fell for the first time in three days as an auction of U.S. two-year notes attracted lower-than-average demand with the Federal Reserve likely moving closer to winding down its asset-purchase program.

The bid-to-cover ratio on the $35 billion in notes, which gauges demand by comparing total bids with the amount of securities offered, was 3.08, compared with an average of 3.54 for the past 10 sales. The Fed will start trimming its $85 billion in monthly bond purchases in September, according to a survey of economists by Bloomberg News released today. The U.S. will sell $35 billion in five-year debt tomorrow and $29 billion in seven-year securities on July 25.

“The market is settling back into the fact that tapering is going to occur,” said Thomas Roth, senior Treasury trader in New York at Mitsubishi UFJ Securities USA Inc. “The market is defining 2.50 percent on 10s as a level that kind of makes sense.”

The U.S. 10-year yield rose three basis points, or 0.03 percentage point, to 2.51 percent at 5 p.m. in New York, according to Bloomberg Bond Trader prices. The 1.75 percent note due in May 2023 fell 6/32, or $1.88 per $1,000 face amount, to 93 15/32.

The current two-year note yield was little changed at 0.31 percent.

Volume, Volatility

Treasury trading volume at ICAP Plc, the largest inter-dealer broker of U.S. government debt, was $246.7 billion, up from $194 billion yesterday, the highest level since July 5. The 2013 average is $318.8 billion.

Volatility in Treasuries as measured by the Merrill Lynch Option Volatility Estimate MOVE Index was at 74.05, up from yesterday’s 72.62, the lowest level since May 24. The figure is down from 117.89 on July 5, the highest since December 2010. The one-year average is 64.8.

Today’s two-year note auction drew a yield of 0.336 percent, compared with a forecast of 0.338 percent in a Bloomberg News survey of seven of the Federal Reserve’s 21 primary dealers.

Demand as measured by the ratio of bids to debt sold was “lighter” than average, said Thomas di Galoma, head of U.S. rates sales at ED&F Man Capital Markets in New York. “The five-year’s going to be a little more difficult just because the five-year sector has rebounded off its lows.”

Bidder Participation

Indirect bidders, an investor class that includes foreign central banks, purchased 30.4 percent of the notes, compared with 35.8 percent at the June sale, the highest since February 2012, and an average of 25.2 percent for the past 10 sales.

Direct bidders, non-primary-dealer investors that place their bids directly with the Treasury, purchased 16.4 percent of the notes at the sale, compared with 7.8 percent last month and an average of 23.9 percent for the past 10 auctions.

Two-year notes have gained 0.1 percent this year, compared with a decline of 2.3 percent by Treasuries overall, according to Bank of America Merrill Lynch indexes. The two-year securities returned 0.3 percent in 2012, while Treasuries overall rose 2.2 percent.

“There’s a general feeling that QE tapering will be happening in September, and it’s not a good scenario for the bond market,” di Galoma of ED&F Man said.

Investors have bid $2.93 for each dollar of the $1.193 trillion in U.S. government notes and bonds sold at auction so far this year, according to Treasury data compiled by Bloomberg. That’s down from the record $3.15 for the $2.153 trillion sold at last year’s offerings.

This week’s three note auctions, totaling $99 billion added to the $15 billion of 10-year Treasury Inflation-Protected Securities sold last week, will raise $54.6 billion of new cash, as maturing securities held by the public total $59.4 billion, according to the U.S. Treasury.

Net Longs

The Fed’s primary dealers trade government securities with the central bank and are obligated to bid in Treasury auctions.

Treasuries investors raised bets the price of the securities will gain in price, becoming the most bullish since November, according to a survey by JPMorgan Chase & Co.

The proportion of net longs, or bets the securities will rise, increased to 10 percentage points in the week ending yesterday, from 8 percentage points the previous week. The figure is the highest level of bullish bets since Nov. 12. The percentage of outright longs rose to 23 percent from 21 percent.

An index measuring 10-day price volatility in Treasuries dropped to 2.44 percent yesterday from 7.49 percent on July 8, which was the highest since November 2011.

The Merrill Lynch Option Volatility Estimate Move Index fell to 72.62 yesterday, the lowest level in almost two months. The figure is down from 117.89 basis points on July 5, which was the most since December 2010. The one-year average is 64.7.

Fed Expectations

None of the 54 economists surveyed by Bloomberg from July 18-22 predicted the Federal Open Market Committee will begin reducing its monthly purchases at its meeting scheduled for July 30-31.

In its first reduction, the FOMC will probably cut monthly bond buying to $65 billion, according to the survey. Economists see purchases divided between $35 billion in Treasuries and $30 billion in mortgage-backed securities.

The Fed has kept its target for overnight bank lending in a range of zero to 0.25 percent since December 2008. It has said it will consider raising the target when the unemployment rate falls to 6.5 percent, versus 7.6 percent as of June.

Fed Chairman Ben S. Bernanke told congressional panels last week it was “way too early to make any judgment” about whether the biggest buyer of Treasuries will start cutting back in September.

Benchmark yields jumped 17 basis points June 19 after Bernanke said the central bank may start dialing down its unprecedented bond-buying program this year and end it entirely in mid-2014 if the economy finally achieves sustainable growth.

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