The stock market is watching the bond market, wary a spike in interest rates will derail a fragile economic recovery and snuff the market's rally. Stocks tumbled Wednesday, but the real drama was in Treasurys and mortgages.A selling spree in Treasurys pushed rates higher, taking the yield curve to its steepest on record as spreads between the 2-year and 10-year widened by over a dozen basis points on Wednesday alone. The 10-year saw its yield move above 3.70 percent, after trading at 3.55 percent the previous day. The selling wave hit bonds shortly after 1 p.m., even after the auction of $35 billion in 5-year notes was well received.
"It was a great auction. It was just the follow through that was a problem," said Brian Edmonds, head of interest rate trading at Cantor Fitzgerald.
Traders are bracing for more of the same Thursday. The Treasury is auctioning another $26 billion in notes, this time 7-years.
The heavy issuance - more than $100 billion this week alone - has been pressuring the market.
Some key data will also get the market's attention Thursday, including weekly jobless claims, durable goods and new home sales.
Traders said selling in Treasurys this week was exaggerated by "convexity" selling, or mortgage related hedging, which causes traders to sell Treasurys as a hedge as mortgage prices move lower and rates go higher.
The Fed, meanwhile, has been an active buyer of mortgages in an effort to keep rates lower, and until the last couple of days, selling in Treasurys did not ripple into the mortgage market. On Wednesday, mortgage spreads widened sharply. In the last couple of days, there have been some dramatic changes.
For instance, David Ader of RBS said a Fannie Mae mortgage with a four-year duration has seen its duration extend to 5.7 years as rates moved higher in just several days. To hedge that move, traders would sell long-dated Treasurys, forcing yields even higher.
"The bear market that has been in Treasurys has finally had an impact on something and that's a big deal," said Ader, who heads rates strategy at RBS. "It means mortgage rates are going up, and that brings into question and challenges the housing market recovery...and the economy."
"What it also does, I think, is prove something of a problem for the Fed because the Fed has spent a lot of money to buy mortgages and keep mortgages rates down, and spent a little money to buy Treasurys and ease the sell off," he said. They feel the housing market is fragile and this could hurt its recovery, and it will. It may encourage them to be more aggressive at buying Treasurys. We are, not deliberately, but provocatively, challenging the Fed here."
Edmonds said he believes the Fed needs to reassess its quantitative easing program and may need to increase it and aim it at different sectors of the curve. "You can't have a spike in interest rates in the long end without it impacting the economy," he said. "That's why the Fed has been a supporter of the quantitative easing. They have a choice. They could walk away from it or they could increase it to the point where it's meaningful. The $300 billion is not effective...You've got to start to talk trillions," Edmonds said.
CNBC's Rick Santelli reported that a big reason for the strength in the 5-year auction was the presence of foreign central banks, also big buyers in Tuesday's 2-year auction. Some traders have speculated that China is among the buyers, coincidentally ahead of Treasury Secretary Timothy Geithner's upcoming China trip this weekend.
Santelli also said the fact that the 5-year auction was "hugely underwater" within hours of the auction results shows that some of the aggressive buyers turned into sellers across the curve. He said some investors had been more aggressive holders of mortgage products recently because of the Fed's purchase program. But an unintended consequence of the program was that those investors were forced into becoming unwilling sellers as mortgage spreads widened.