Debt Fears Send Rates Up

By TOM LAURICELLA

A sudden drop-off in investor demand for U.S. Treasury notes is raising questions about whether interest rates will finally begin a march higher—a climb that would jack up the government's borrowing costs and spell trouble for the fragile housing market.

For months, investors have focused their attention on the debt crisis in Europe, but there are signs the spotlight is turning to the ability of the U.S. to finance its own budget deficit.

This week, some investors turned up their noses at three big U.S. Treasury offerings. Demand was weak for a $44 billion 2-year note auction on Tuesday, a $42 billion sale of 5-year debt on Wednesday and a $32 billion 7-year note sale Thursday.

The poor demand, especially from foreign investors, sent the bonds' prices sharply lower and yields higher. It lifted the yield on the 10-year note to 3.9%—its highest since last June, and approaching the psychologically important 4% mark. That mark has been pierced only briefly since the financial crisis in 2008.

Investors' response marked a big shift from auctions in recent months in which major foreign buyers, such as central banks, had snapped up Treasurys. It could spell trouble for the U.S. housing market; the rates on many mortgages are linked to the yield on the 10-year note.

The move up in its yield coincides with the impending end of the Federal Reserve's program to support the mortgage market. The Fed has bought $1.25 trillion of mortgage-backed securities, bolstering their prices and thus holding down their yields.

In the past two days, mortgage rates have also ticked up. The average 30-year mortgage rate rose to 5.13% on Thursday from 5.06% on Monday, according to HSH Associates in Pompton Plains, New Jersey.

Concerns about the U.S. budget deficit are beginning to hurt the Treasury market, says Steve Rodosky, head of Treasury and derivatives trading at bond giant Pacific Investment Management Co. He says he is increasingly worried about the U.S. fiscal outlook. "The government needs to take real action rather than pay lip service" to addressing the fiscal problems.

In all, the U.S. government is expected to sell $1.6 trillion in debt this year, including the $118 billion sold this week.

There are some temporary factors behind the lackluster demand for this week's Treasury offerings, such as a reluctance by Japanese investors to make new investments ahead of their fiscal year-end March 31.

While this could be just "noise" in the markets, "I think it involves a greater, long-term concern about deficits in the U.S. last 10 or 20 years, about Social Security being in a deficit," said Brian Fabbri, chief economist North America at BNP Paribas. "And all of the concerns about the U.S. have been heightened by concerns about Greece."

The jitters in Treasurys haven't spread to other markets. Stocks remain near 18-month highs. The Dow Jones Industrial Average came within 45 points of the 11000 mark on Thursday before falling back. It closed up 5.06 points at 10841.21.

Bruce Bittles, a strategist at R.W. Baird & Co., said he remains bullish on stocks for now. But he said if the yield on 10-year Treasurys creeps above 4%, that would be an important signal to start dialing back his clients' stock holdings. "In a debt-based economy like we have in the U.S., it doesn't take much of a hit from bond yields to cause some real pain," by raising costs to finance economic activity, Mr. Bittles said.

The dollar has rallied, even as Treasurys have sold off. Usually, concerns about budget deficits send a currency lower. But investors appear to be betting on better prospects for a recovery in the U.S. than in Europe.

Adding to the focus on the Treasury market's woes this week has been an unusual development in an important, but usually ignored, market: interest-rate swaps. These common derivatives entail contracts that typically involve trading one stream of interest income for another. And in the past week, investors are being paid more to own U.S. Treasurys than U.S. corporate bonds.

This development "is causing a lot of people to start scratching their heads, trying to understand what's going on," said BNP's Mr. Fabbri. One explanation, he said, may be investors are more comfortable with the risks of owning bonds backed by U.S. corporations than the government. The big question is whether this fall in demand for Treasurys, and spurt in their yields, will prove temporary or is the start of a trend.

For the most part, investors have taken at face value statements from Federal Reserve officials, including Chairman Ben Bernanke on Thursday, that the Fed isn't about to start raising the short-term rate it controls. But a growing number of investors expect at its next policy-making meeting in late April, the Fed may step back from its pledge to keep short-term rates low for an "extended period."

Longer-term interest rates aren't set by the Fed but move on their own, in response to supply and demand. And some argue that the bond market has been too confident about these longer-term rates remaining low—at a time when the economy is slowly improving and the government is running huge budget deficits.

—Deborah Lynn Blumberg, Min Zeng and Prabha Natarajan contributed to this article.

Write to Tom Lauricella at tom.lauricella@wsj.com