Bond bust fears overblown - for now

(breakingviews.com) -- The U.S. Treasury bond market has been feeling distinctly unloved. A 10-year bond auction went badly on June 10 after Russia, Brazil and China said they were taking steps to diversify their foreign currency reserves.

Worries that Thursday's $11 billion auction of 30-year bonds would follow suit rattled the market. But central banks flocked to buy the bonds, meaning dollar diversification fears were overblown -- at least for now.

Treasury officials may be relieved, but they shouldn't relax. The factors that could push up the cost of issuing U.S. government debt continue to mount. The behavior of the inflation-linked bond market shows investors are beginning to worry more about inflation than deflation, as signs of an approaching economic recovery proliferate. And the sheer volume of debt the U.S. has to issue this fiscal year -- $3.25 trillion worth, or nearly four times as much as last year -- has unnerved investors.

Nonetheless, the 30-year bond auction received a lot more interest than usual. The ratio of total bids to accepted bids, an indicator of demand, was 2.68, up from an average of 2.21 in recent auctions. Encouragingly, foreign investors, mainly central banks, purchased nearly half the bonds. They normally take only about a third.

That's notable because big Treasury bond investors like China have been shifting their purchases toward shorter-term securities to reduce their risk of loss from interest rate rises.

And that's a significant risk. The 4.72% yield at which the bonds were sold was admittedly the highest at auction in nearly two years. But assume inflation returns to a long-term average of about 3%, and the real return on the bonds starts to look parsimonious. Add the likelihood of long bond yields rising significantly at times over three decades, and the price of this bond could slide.

While the willingness of foreign central banks to shoulder this risk is encouraging, Treasury officials shouldn't be high-fiving each other just yet. The long bond has plummeted 10% in price in the last month alone. The patience of many foreign investors is already strained. Some may soon reach their limit.