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U.S. 3-year Treasuries sale heightens bubble worries

NEW YORK (Reuters) - Signs of fraying demand for U.S. government debt on Wednesday, especially among foreign buyers, are adding to concerns of a bursting Treasury price bubble, with potentially huge consequences for the world’s top economy.

Foreign accounts, which own about half the $5.8 trillion U.S. Treasury market, bought less than usual at a record $30 billion sale of three-year U.S. notes.

The auction was part of Washington’s massive ramp up of some $2 trillion of debt issuance this year to pay for rescues of the U.S. financial system, the auto industry and for other measures to dig the economy out of its worst crisis in decades.

Yields, or returns on shorter-dated Treasury notes, sank to record lows in mid-December as panicked investors scrambled to get out of riskier assets, such as stocks and company debt.

Now investors have started to balk at the record low yields that government securities offer, analysts say. Any spike in yields could add to borrowing costs for cash-strapped companies and homeowners, further crippling an already hobbled economy.

“As the year has switched, a lot of people are starting to re-evaluate how low the Treasury yields are: the sticker shock,” said William Larkin, portfolio manager with Cabot Money Management in Salem, Massachusetts.

In the last days of 2008, investors started venturing tentatively into stocks and corporate bonds whose yield spreads over Treasuries had hit all-time highs.

That is the first reason for the recent sell-off in the Treasury market, Larkin said, which has pushed the benchmark 10-year note yield up about 50 basis points from its five-decade low of 2.04 percent hit in mid-December.

“The second part is the looming amount of debt the government will have to auction off,” said Larkin. “There will be a huge amount of supply and even competing types of investments, including lots of new sovereign debt globally.”

Foreign central banks may need to keep cash at home to support their foundering economies amid the global credit crisis and may invest less in U.S. debt, especially if the fiscal position of the United States deteriorates markedly, some analysts expect.

Indirect bidders, including foreign central banks, took about 28 percent of Wednesday’s 3-year note sale, below the 35 percent taken in a 3-year note sale in December. The U.S. government reintroduced 3-year note sales in November as part of its huge debt issuance acceleration.

Not everyone is worried about foreign demand, most importantly from China and Japan, the two biggest foreign holders of U.S. Treasuries, owning more than $1 trillion of these securities. Such cash-rich Asian countries have funded much of the U.S. spending spree under the administration of President George W. Bush, and some analysts are concerned about such heavy reliance on these countries for financing.

U.S. President-elect Barack Obama said on Wednesday that an economic stimulus package he plans would likely be at the high end of estimates. Obama’s economic advisers have put a price tag of about $775 billion on the package, while some economists have said it should be as much as $1 trillion to be effective.

For now, weekly Federal Reserve data shows that foreign central banks continue solidly buying Treasuries, says Bill Sullivan, chief economist with JVB Financial Group in Boca Raton, Florida.

“I don’t think that will change any time soon. The custody holdings show very strong demand,” Sullivan said.

As the economy continues to deteriorate, safe haven demand for government securities should remain solid for some time to come, he added.

Even so, bond investors viewed Wednesday’s auction as weak and Treasuries swiftly accelerated their losses in the debt markets after the sale.

“Certainly foreign demand is not as strong as what we had seen in the previous auctions as the foreigners are buying less of our Treasuries,” said Mary Ann Hurley, senior Treasuries trader in Seattle at brokerage D.A. Davidson.

“They have to devote more of their own cash reserves to domestic programs in their respective countries,” Hurley said.

A rebound in shorter-dated U.S. note yields, as the price offered by investors falls, may presage a huge jump in longer maturity Treasury yields, which are more vulnerable to the persistent effects of burgeoning government debt issuance.

The next major test of demand for the benchmark 10-year note comes with a $16 billion auction of this maturity scheduled for Thursday.

Reporting by John Parry; Editing by Kenneth Barry