Bond market fires shot across U.S. bow

NEW YORK (CNNMoney.com) -- Treasury prices drifted higher Friday as investors moved to take advantage of sharply higher yields following a lukewarm auction of $118 billion in U.S. notes earlier this week.

The benchmark 10-year note rose 9/32 to 98-6/32, pushing the yield down to 3.85%. Bond prices and yields move in opposite directions.

The 2-year note gained 2/32 to 99-29/32 with a yield of 1.06%. The 30-year bond rose 7/32 to 98-2/32 with a yield of 4.75%.

Despite the modest rebound on Friday, Treasurys are on track to post a weekly decline as investors fret about weakening demand for U.S. debt.

The yield on the 10-year note surged Thursday to a high above 3.9%, the highest level since June, after a sale of $32 billion worth of 7-year notes drew tepid demand.

Demand at this week's 2-year and 5-year note auctions was also lukewarm, which has raised speculation that a long-awaited boycott of U.S. debt could be near.

"The message from the bond market to Washington is loud and clear," said Mike Larson, an interest rate analyst at Weiss Research. "Get your fiscal house in order or we'll force you to do so."

Many analysts have been predicting that investors will eventually begin demanding higher yields, given the flood of Treasurys that has come to market over the last several months and the risks tied to the swelling U.S. budget deficit.

Until this week, demand for Treasurys had been relatively robust as investors flocked to the safety of U.S. debt amid the financial crisis.

More recently, demand had been supported by concerns about the fiscal crisis brewing in Europe, where debt-stricken countries such as Greece threaten to drag down economic activity across the region.

That healthy demand has been a boon for the U.S. government, which has been able to fund its activities and finance its debt at attractive rates. It has also helped stabilize the nation's fragile housing market, since mortgage rates are linked to Treasurys.

However, with policy makers in Europe moving this week toward an agreement on a deal to aid Greece if necessary, investors are turning their attention to the debt woes facing the Untied States.

"Now that the Greece situation looks like it could be resolved, the focus is shifting to the fairly ugly U.S. fiscal outlook," said Kim Rupert, a fixed-income analyst at Action Economics.

The U.S. is expected to sell over $1 trillion worth of Treasurys this year after selling a similar amount last year. The national debt, as a percentage of gross domestic product, is expected to hit 10% this fiscal year, according to Moody's Economy.com.

At the same time, investors have been moving away from Treasurys to take advantage of more attractive opportunities in the market for corporate bonds. At one point this week, yields on some corporate securities were trading below the yield on the benchmark 10-year Treasury note.

In addition, many analysts expect Treasury yields will continue pushing higher as the economy slowly recovers and investors grow more concerned about inflation. Rising prices can severely erode the value of fixed-income assets such as Treasurys.

"It's going to be a stop-and-go process, but we will see rates move higher," said Gus Faucher, director of macro economics at Moody's Economy.com. "If buyers of Treasurys are concerned that the government is not going to get its fiscal house in order, they will push rates up."

However, the nation's debt levels will eventually decline as the economy recovers, boosting tax revenues and reducing demand for social services, he said. And the Federal Reserve has tools to offset the impact of an increase in Treasury yields, he added.

Still, he cautioned that a rapid rise in Treasurys could have negative consequences for the broader economy.

"Rates will need to move higher, but you don't want it to happen too quickly and choke off the recovery," he said.