Treasuries drop as 3-year auction draws highest yield since 2011

NEW YORK – Treasuries fell a third day as the United States sold $28 billion of three-year securities at the highest yield since May 2011 amid signs the economic expansion is strengthening.

Yields on current three-year notes rose to a three-month high as small-business optimism rose to the highest level since before the worst recession since the Great Depression, adding to speculation the Federal Reserve will start raising interest rates next year. Goldman Sachs Group Inc. said it sees yield spreads between U.S. government bonds due in more than five years and their euro-area counterparts compressing. The U.S. plans to sell $21 billion of 10-year securities Wednesday and $13 billion in 30-year bonds on June 12.

“Between the upcoming Fed meeting and supply considerations later this week, not to mention a generally bearish trend for the Treasury market overall, ambition to add exposure to front-end Treasuries has been muted,” Ian Lyngen, a government-bond strategist at CRT Capital Group LLC in Stamford, Conn.

Three-year yields rose three basis points, or 0.03 percentage point, to 0.89 percent at 1:17 p.m. New York time after touching 0.89 percent, the highest since May 8, according to Bloomberg Bond Trader data. The 0.875 percent note due in May 2017 fell 3/32, or 94 cents per $1,000 face amount, to 100 31/32.

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Benchmark 10-year yields climbed four basis points to 2.64 percent, rising for a third day and an eighth day in nine. They touched 2.65 percent, the highest since May 13, and have gained from 2.4 percent on May 29, the lowest level since June 2013.

The Bloomberg Global Developed Sovereign Bond Index has returned 3.9 percent this year, compared with a loss of 4.6 percent in 2013.

Notes auction

The three-year notes sold Tuesday yielded 0.930 percent, compared with a forecast of 0.924 percent in a Bloomberg News survey of eight of the Federal Reserve’s 22 primary dealers.

The bid-to-cover ratio, which gauges demand by comparing total bids with the amount of securities offered, was 3.41, versus 3.4 at the last sale.

Indirect bidders, an investor class that includes foreign central banks, purchased 26.5 percent of the notes, compared with an average of 33.6 percent at the past 10 sales. Direct bidders, non-primary-dealer investors that place bids directly with the Treasury, purchased 19.4 percent, compared with an average of 18.8 percent at the past 10 auctions.

New cash

Three-year notes have returned 0.5 percent this year, compared with a gain of 2.6 percent by the broader Treasuries market, according to Bank of America Merrill Lynch indexes. The three-year securities lost 0.1 percent in 2013, while Treasuries overall fell 3.4 percent.

The sales will raise $30 billion of new cash, as maturing securities held by the public total $32 billion, according to the U.S. Treasury.

Treasuries fell earlier as optimism among small-businesses rose to 96.6 in May from 95.2 the prior month, the National Federation of Independent Business reported, the highest since September 2007. The median forecast of 16 economists and strategists in a Bloomberg survey was for a reading of 95.8.

“If small businesses are turning more optimistic, that’s generally positive for the economy as a whole,” said Gary Pollack, who manages $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York. “If that’s the case, you might see slightly upward pressure on yields.”

Fed tapering

Fed Bank of St. Louis President James Bullard told reporters in Palm Beach, Fla., Monday that an improvement in the economy in line with his expectations “will change the conversation about monetary policy, and there will be more sentiment toward an earlier rate hike.” Bullard doesn’t vote on the Federal Open Market Committee this year.

The Fed is tapering its monthly asset purchases, while keeping the target for overnight lending between banks in a range of zero to 0.25 percent. Policy makers signaled at their April 29-30 meeting that interest rates will stay low for a “considerable time.” They next meet on June 17-18.

“The focus is going back to the economy and how the Fed responds to that – old-school trading,” said Thomas Roth, senior Treasury trader in New York at Mitsubishi UFJ Securities USA Inc. “The market in May was getting away from the economic numbers.”

Rate expectations

The chance of a rate increase to 0.5 percent or more by March 2015 is 16 percent, according to data compiled by Bloomberg based on federal fund futures. The odds of an increase by December of next year are 72 percent.

Shorter-maturity debt tends to track what the Fed does with its benchmark rate, while longer-term securities are more influenced by the outlook for inflation.

Goldman Sachs sees an opportunity to bet that the additional yield investors demand to hold U.S. debt due in more than five years over equivalent euro-area securities will narrow after the European Central Bank unveiled an unprecedented package of stimulus measures last week, according to Francesco Garzarelli, co-head of macro and markets research. The company is one of the 22 primary dealers that trade with the Fed.

“For maturities beyond five years, that spread is very wide,” he said in an interview on Bloomberg Television. “The Fed may raise rates earlier than the market thinks and that should flatten the yield curve in the U.S. If the ECB action takes traction that should steepen the European yield curve so on a forward basis that spread compresses.”

The Treasury five-year yield spread with equivalent- maturity German bonds widened to 127 basis points, up from 82 basis points at the start of the year and the most since July 2006.

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