TREASURY MARKET FIRES WARNING SHOT / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

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MARCH 29, 2010, 1:53 P.M. ET.

Treasury Market Fires Warning Shot

By RICHARD BARLEY

Jitters in the Treasury market: a technical blip or evidence that U.S. fiscal woes are finally starting to test the patience of bond investors? Last week bond auctions struggled, 10-year yields surged to 3.88% from 3.7%, and 10-year yields rose above 10-year swap rates for the first time in living memory—all indicators of market stress.

Fiscal worries certainly triggered the initial market wobble. The passage of the $940 billion health-care bill reignited concerns about the U.S. deficit, pushing yields up and narrowing the gap to swap rates, which tends to be driven by expectations of government bond supply. A negative spread could indicate lack of demand for Treasurys or doubts over U.S. creditworthiness.

But the health-care and deficit debates aren't new. Technical factors also appear to have played a role in the sell-off. At the same time as Treasury yields started rising, swap rates were being pushed lower by banks seeking to hedge their exposure to fixed interest rates following recent heavy bond issuance.

Together, these factors served to start pushing swap spreads toward zero. That seems to have caught out some speculators who were betting the traditional spread would reassert itself. These investors were then forced to sell Treasurys to close their positions, leaving dealers unexpectedly long, leading to reduced demand for new bonds at auction, higher Treasury yields and sharply negative swap spreads.

Sure, negative spreads don't pose an immediate threat to U.S. borrowing costs. In the U.K., where fiscal worries are more urgent, 10-year swap spreads have been negative since early February. Standard & Poor's Monday reiterated it may yet downgrade the U.K. from triple-A unless more credible action is taken to reduce the deficit.

Still, next week's potentially tricky auctions of U.S. 10-year and 30-year Treasurys have now taken on a greater significance. The Treasury will be hoping demand will pick up following the quarter end, with dealers perhaps willing to take on more risk. However any repeat of last week's lackluster results would suggest the U.S. may not have as much room for fiscal maneuver as it thinks.

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