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Who Needs Stress Test Results When There's A Messy Treasury Bond Auction?

In the last few months, investors have attempted to use almost every asset there is as a bellweather for risk appetite. But there's no better example than the safest one in the world: U.S. Treasury Bonds.

Earlier today, the government auctioned $14 billion of 30-year bonds with a surprisingly high yield: 4.28 percent. That was 18 basis points higher than the average forecast by analysts. The price of Treasuries began to fall immediately as news of the lackluster demand spread.

That may well be a better sign about the true health of the financial system than the results of the stress tests, released later today. With all the chaos in the banking sector recently, demand for Treasuries has been exceptional. Now, investors are giving the first real show of a "thumbs up" at prospects for a healthier economic outlook in 2009.

The auction follows an announcement by the European Central Bank earlier that it will buy $80.5 billion of euro-denominated corporate "covered" bonds in order to provide further liquidity to financial institutions there. Covered bonds are bonds secured by property loans on banks' balance sheets.

The immediate effect of these two announcements is likely to be a big decline in the value of the U.S. dollar. Lately, the dollar has rallied as risk-shy investors have gone on a purchasing binge of Treasury bonds. Further buying by the ECB of European corporate debt will only exacerbate the pressure on the dollar as the euro rises against it. In other words, risk appetite is coming back in a big way.

A second effect remains to be seen. If U.S. Treasuries begin to lose lots in value over the coming weeks, then it's not unlikely that the Chinese may be tempted to buy more. Last quarter, China purchased just $7.7 billion of Treasury bonds. That represented a whopping decrease of $146.2 billion on the same period last year, when there was much less demand around for the paper (and hence cheaper prices).

If China does begin buying more Treasuries, then that effect is only likely to fuel risk appetite even more, as the country sends the message that it is prioritizing exports again -- as opposed to domestic consumption, which only benefits the Chinese.

The long and short of it is that the bond market may be our best gauge of how events play out over the next quarter.

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