As QE2 Sets Sail, Bond Rally Sinks

By MATT PHILLIPS And MIN ZENG

Just as the Federal Reserve is about to step away from the market, the months-long Treasurys rally is showing signs of pulling back.

The yield on the benchmark 10-year note reached 3.11%, its highest since May 25. Yields on the 10-year note have risen every day this week, adding about 0.24 percentage point since Friday and sparking speculation that the bull run in the bond market may have passed its peak.For the third consecutive session, Treasury investors on Wednesday balked at buying new bonds at a large government-debt auction, sending prices lower and yields higher.

The Treasurys on sale on Wednesday were $29 billion of seven-year notes. That followed sales of two- and five-year notes, all of them showing low levels of demand in the private sector and among foreign buyers.

The poorly received auctions raised eyebrows ahead of Thursday's official finish of the Federal Reserve's second bond-buying initiative, a $600 billion "quantitative easing" program widely known as QE2.

And some see signs that the 20 primary dealers, who trade directly with the Federal Reserve and are obligated to bid on Treasury bond auctions, are getting gun shy about bidding aggressively in auctions, knowing the Fed won't be there as a guaranteed buyer to take unwanted Treasurys off their hands.

And there will be plenty of extra supply to swallow."It's really the dealer community who, to some degree, is stuck absorbing that extra supply in Treasurys," said Fidelio Tata, head of U.S. interest-rate strategy at Société Générale in New York. "And they're not happy about it."

Since QE2 began, the Fed has bought about 85% of the net Treasury issuance over the past eight months or so, according to Morgan Stanley economists.

In each of the first six months of this year, the Fed bought all but $17 billion of the Treasurys sold by the government, J.P. Morgan estimates. Once QE2 ends, private buyers will be forced to soak up $94 billion a month.

"In order to get the private sector to absorb that supply, it's going to take a concession. It's going to take higher yields," said Terry Belton, global head of fixed income strategy at J.P. Morgan.

The Fed isn't taking the training wheels completely off just yet. The central bank will continue to buy Treasurys with the proceeds from repayments on the remaining mortgage-backed and Treasury debt it owns. With interest rates at current levels, Bank of America Merrill Lynch estimates that will result in about $15 billion worth of Fed buying a month. But that pales in comparison to the size of Fed purchasing in recent months.

In a speech in February, Brian Sack executive vice president of the markets group at the Federal Reserve Bank of New York, said that QE2 involved the Fed buying "more Treasury securities than the amount currently held by the entire U.S. commercial banking system."The Fed ends QE2 as a bigger holder of Treasurys than China, according to Treasury and Fed data, owning roughly 17% of U.S. marketable debt.

"The Fed was the largest source of duration demand since November last year, so it's extremely important," said Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch. "The big question is: What is the buyer that steps in? And at what price?"

"But the Greek and the euro-zone debt problems are far from being solved,'' said Michael Franzese, head of Treasury trading at Wunderlich Securities in New York. "I am buying on 'dips' here. I don't think the bull run in Treasurys is over yet, though selling dominates in the short term in the overbought market."Besides the looming end of QE2, signs of Greece being able to avoid a default next month pushed many investors to unload safe-haven Treasurys in favor of stocks.

In late-afternoon trading, the benchmark 10-year note was down 18/32 points, pushing the yield up to 3.110%. The 30-year bond was down 21/32 to yield 4.372%. The two-year note was up 2/32 points to yield 0.469%.