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Will Auctions Draw Enough Bidders? -- WSJ

17 Nov 2017 7:32 am
By Daniel Kruger 

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the U.S. print edition of The Wall Street Journal (November 17, 2017).

As the Treasury Department prepares to increase its short-term borrowing, some investors are concerned that the rising size of its auctions raises risks that could spark selling in the bond market.

Since the financial crisis, the bond dealers the Treasury relies on to make sure its offerings are fully subscribed have been buying much less debt. That leaves the agency relying on investors -- ranging from mutual funds to foreign central banks -- to pick up the slack.

Dealers, investors and analysts say a sudden drop-off in bidding at auctions could produce a rapid rise in yields. Bond yields rise when prices fall. Such an increase in yield could send ripples throughout the economy.

The surge in borrowing "will make the auction process larger and more volatile," said Robert Tipp, chief investment strategist at PGIM Fixed Income. Throw in "tax cuts and expanding the budget deficit, and you have an entitlement nightmare out there, then you're increasing the risks in the system."

Some traders, however, note that problems stemming from a poor auction could be limited to a particular offering, and that investor concerns about rising yields have persisted even as yields have remained near modern lows over the past nine years.

Before the financial crisis, government bond auctions were managed by the trading desks of the largest bond dealers. Working within a network of trading firms, known as primary dealers and overseen by the Federal Reserve's New York branch, the biggest banks bought 67% of the debt sold by the government, which they would then resell to clients. Today, they buy just 30% of government issuance, with investors buying the rest.

While Treasury data suggests dealers have been bidding less aggressively at auctions this year than since data became available, they play an essential part in the government's funding operations. This year, investors have won 80% of the $1.54 trillion in bonds they have bid for. But investor bids aren't enough by themselves to fully meet the more than $2 trillion in annual government borrowing needs.

The bond business has become more difficult for dealers since the crisis. Banks have reduced the amount of money they commit to trading Treasurys after Dodd-Frank banking rules restricted them from trading corporate bonds and other risky assets in proprietary accounts, which had long been one of the more lucrative segments of bond trading.

One problem is that about half of all Treasury trading is concentrated in the hands of about five of the 23 primary dealers, according to Celent, a consultancy. That concentration makes it more difficult for smaller firms to support Treasurys trading after the auctions. Diminished engagement of a sizable amount of dealers is "a recipe for trouble," said one official at a primary dealer firm. "I'd be concerned about it, from the perspective of the Fed and Treasury."

Investors and government officials may be not be prepared for the impact of the additional borrowing on the auction process, and on market rates. They "know it's coming, in theory," said Tom Pluta, co-head of global rates trading at J.P. Morgan Chase. They "may be underappreciating what that looks like."

(END) Dow Jones Newswires

November 17, 2017 02:32 ET (07:32 GMT)

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