U.S. Two-Year Notes Approach Highest Auction Yield Since 2011

Treasury two-year notes were set to be sold today at the second-highest yield at an auction of the security since 2011 on speculation the Federal Reserve will raise interest rates before the debt matures.

Benchmark 10-year note yields touched the highest level in more than two weeks as a report showed the Richmond Fed manufacturing index rose more than forecast in April, reinforcing the central bank’s view that the economy is improving and stimulus cuts are warranted. The two-year securities have returned 0.3 percent this year through yesterday, compared with 1.9 percent for the broader Treasury market, according to Bank of America Merrill Lynch indexes.

“The economy is improving and it puts pressure on yields,” said Charles Comiskey, New York-based head of Treasury trading at Bank of Nova Scotia in New York, one of 22 primary dealers that trade with the Fed. “There’s selling going on.”

The benchmark 10-year yield rose two basis points, or 0.02 percentage point, to 2.73 percent at 11:45 a.m. in New York, according to Bloomberg Bond Trader data. The price of the 2.75 percent note maturing in February 2024 declined 1/8, or $1.25 percent $1,0000 face amount, to 100 1/8. The yield reached the highest level since April 4.

Trading Pace

Treasury trading volume dropped yesterday to $146 billion, the least since Dec. 27, according to ICAP Plc, the largest inter-dealer broker of U.S. government debt. It reached $582.4 billion on March 13, the highest in more than nine months, according to ICAP.

The Bloomberg Global Developed Sovereign Bond Index has gained 3.4 percent this year, versus a 4.6 percent decline in 2013.

Treasuries remain attractive versus their Group of Seven counterparts. Ten-year notes yielded 66 basis points more than their G-7 peers. The difference touched 67 basis points on April 18, the most in four years, as the Fed unwinds its bond-buying program while Japan and Europe consider additional purchases.

The $32 billion of April 2016 notes being sold yielded 0.45 percent in pre-auction trading. The monthly two-year auction in March drew a yield of 0.469 percent, the highest level since a sale in May 2011. The yield on previously issued two-year securities was little changed at 0.40 percent.

Auction Outlook

“Yield level is the main driver at today’s auction,” said Michael Franzese, senior vice president of fixed-income trading at ED&F Man Capital Markets in New York. “We’re getting some type of pullback. That could be a nice little concession.”

At the March 25 two-year note auction, the bid-to-cover ratio, which gauges demand by comparing the amount bid with the amount offered, was 3.20, compared with 3.6 at the previous auction and the average ratio for the past 10 auctions of 3.32.

Indirect bidders, a class of investors that includes foreign central banks, bought 40.9 percent of the securities at the March sale, the most since November 2011. The average at the past 10 auctions was 28.6 percent.

Direct bidders, non-primary-dealer investors that place their bids directly with the Treasury, purchased 21.5 percent of the notes at the last offering, compared with an average of 22.4 percent at the past 10.

The Treasury is scheduled to auction $35 billion of five-year notes tomorrow and $29 billion of seven-year debt on Thursday.

Fed Policy

The Fed is in the process of phasing out the bond-purchase program it has used to help support the economy. It purchased $1.02 billion in notes maturing between November 2039 and August 2043 today.

The central bank has kept its target for overnight bank lending in a range of zero to 0.25 percent since December 2008. Policy makers next meet on April 29-30.

The implied yield on 30-day federal funds futures contracts expiring in October 2015 was 0.565 percent, indicating investors expect the benchmark rate to be at least a quarter percentage point higher by then.

“Mid-2015 is a good estimate,” said Piet Lammens, head of research at KBC Bank NV in Brussels, referring to the timing of the Fed’s first rate increase. “The U.S. economy is in a better shape than is thought. The Fed will have to act somewhat faster in 2016.”

Yellen Stance

Fed Chair Janet Yellen signaled after the previous policy meeting on March 19 that the central bank may increase borrowing costs in the middle of next year. This month, she emphasized her commitment to support the recovery.

An index measuring manufacturing in the region covered by the Fed Bank of Richmond rose to 7, compared with negative 7 in March. The forecast was for a rise to 2.

The negative outlook on the U.S.’s AAA credit-ranking was changed to stable by DBRS Inc. amid declining federal budget deficits and after Congress suspended the nation’s debt limit earlier this year until 2015.

The Toronto-based ratings company’s adjustment follows decisions by Moody’s Investors Service and Standard & Poor’s last year to change their outlooks on the U.S. to stable from negative. S&P stripped the nation of its top grade in August 2011, citing, in part, political discord about the debt limit. Moody’s gives the nation its top Aaa grade.

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