Big tests loom for government bonds in Europe, U.S.

 Government bond sales in Europe and the U.S. in the next two days could tell a lot about the near-term direction of interest rates in both markets. Europe’s government-debt crisis may be reaching a new tipping point, after investors in the last few months have demanded ever-higher yields on bonds of many of the euro-zone’s financially weakest countries.

Portugal now is looking for a vote of confidence from markets: The country -- considered the next likeliest candidate for a European Union bailout -- hopes to sell four-year and 10-year bonds on Wednesday.Though Portugal has insisted that it won’t follow Greece and Ireland down the bailout path, the country can only avoid that fate if it can borrow from private investors at affordable interest rates.

Since early August the annualized yield on 10-year Portuguese bonds (charted at left) has surged from 5.0% to a recent high of 7.1% on Friday -- a reflection of the rising risk investors see in holding the debt given the country’s financial woes.

In an encouraging sign for Wednesday’s sale, the market yield on Portuguese 10-year bonds has pulled back the last two days, ending Tuesday at 6.9%. Traders have cited heavy buying of Portuguese and other distressed euro-zone bonds by the European Central Bank, which has been trying to shore up the debt markets as private investors have fled.

But if the new bond sales go poorly, and the market senses that Portugal will have no choice but to turn to the European Union for future funding, the effect could be to drive up yields on bonds of other countries whose finances are considered shaky -- including much more important economies such as Belgium, Spain and Italy.

“If Portugal has to go begging for money . . . then the sovereign debt crisis will spread quickly to other, bigger, euro-zone countries,” Carl Weinberg, chief economist at High Frequency Economics in Valhalla, N.Y. warned in a note to clients on Tuesday.

After Portugal comes to market on Wednesday, Italy is scheduled to sell longer-term bonds on Thursday. Meanwhile, the U.S. Treasury plans to sell $21 billion of 10-year notes on Wednesday and $13 billion of 30-year bonds on Thursday. Despite our massive budget deficit, the U.S. still is paying low rates to borrow compared with what most of Europe pays. On Tuesday the Treasury easily sold $32 billion of new three-year notes at a yield of 1.03%.
The outstanding  10-year Treasury note yield (charted at right) ended at 3.34%, up from 3.30% on Monday, ahead of Wednesday’s sale.
Treasury yields have been trading in a narrow range for the last month after rising sharply in October and November. A strong investor reception for the 10-year and 30-year bonds could encourage the view that yields won’t have to rise much higher in the near term to draw buyers.