With the focus on the US debt markets to start the new year, and the FOMC minutes showing that they are in favor of reducing the balance sheet, the focus in the markets turns toward the treasury auctions and more specifically investor demand.

US debt is still met by decent demand from the domestic and international investors. That is a result of the AAA rating for US debt. Foreign governments, insurance companies, pension funds will always have an underlying demand the safety of the US debt.

However, it is the relative demand that has an influence on interest rates.

With the Fed a major source of that demand for US debt, the slowing of their buying - all things being equal - should have an impact on overall demand and with it, rates as well (the taper is not done).

What will the impact be on the auctions?

The treasury just announced that they will auction off $52 billion a three year notes, $36 billion of 10 year notes, and $22 billion of 30 year bonds next week. The markets will be focused on the relative demand in those auctions.

Demand four US debt is commonly measured by things like the six month average of the

  • bid the cover, which is the number of bids in dollar terms versus the auction amount,
  • the average of the direct bidders (measures domestic demand), and the
  • indirect bidders (which is a measure of international demand).

The auction results will tell the story. If the number of bids is less, if domestic and international demand starts to slow, and the US primary dealers who make markets in US debt are left holding more of the bag, it could lead to a further spike in rates.

To mitigate the risk, the markets, between now and the auctions, may (all things being equal) also look to push rates higher in an attempt to attract demand at higher rates.

Now, the Fed has so far not exhausted their buying appetite (it is less but they still buy). They also are still buying treasuries to replace maturing issues, keeping the balance sheet intact.

As a result, this will be a process and the focus by traders, not only this month, but in the months ahead. The implications of sharp moves higher in rates could be felt in economic growth, inflation, housing, and stocks. It could also lead to a higher US deficit as the government this forced to pay higher rates to attract capital to fund the deficit.

Currently the three year yield is at 1.13%, the 10 year yield is at 1.735%, and the 30 year yield is at 2.1313%.Lets see what happens at the auctions next week?