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Treasuries See U.S. Falling Over Cliff as Yields Converge

By Susanne Walker and John Detrixhe
November 13, 2012 3:45 PM EST 108 Comments
The biggest Treasury rally in five months is underlining market concern that President Barack Obama and House Republicans will fail to avert $607 billion in mandated spending cuts and tax increases starting Jan. 1.
Photographer: Andrew Harrer/Bloomberg
The biggest Treasury rally in five months is underlining market concern that President Barack Obama and House Republicans will fail to avert $607 billion in mandated spending cuts and tax increases starting Jan. 1.

The biggest Treasury rally in five months is underlining market concern that President Barack Obama and House Republicans will fail to avert $607 billion in mandated spending cuts and tax increases starting Jan. 1.

Yields on 10-year Treasuries dropped the most in one day since May to 1.62 percent after Obama’s re-election Nov. 6. A figure below 1.7 percent indicates that investors expect gross domestic product to shrink by 0.3 percent next year as the so- called fiscal cliff takes effect, according to JPMorgan Chase & Co. Rates on longer-term Treasuries have converged with those of non-U.S. government bonds globally, after remaining about 1 percentage point above them in 2011.

While the economy is creating jobs, housing prices are recovering and consumer confidence is the highest in five years, bond investors are seeking safety from a possible downturn next year. Yields dropped to a two-month low on the prospect of a divided Congress stalling any budget deal and impeding the recovery from the worst recession since the Great Depression.

“The fiscal cliff is being priced in because it’s the biggest risk facing the market right now,” Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch in New York, one of the 21 primary dealers that trade with the Federal Reserve, said Nov. 7 in a telephone interview. “Without the cliff we would grow 2 to 2.25 percent.”

GDP Cut

The Congressional Budget Office said Nov. 8 the tax rises and spending cuts would cause GDP to contract 0.5 percent in 2013 and push unemployment to 9.1 percent in the fourth quarter of next year. The jobless rate was 7.9 percent in October.

Obama and House Speaker John Boehner are already staking out negotiating positions. The president in a Nov. 9 statement repeated a campaign pledge to let income levies rise for wealthier Americans. The Republican congressional leader said the same day he wanted to avoid any rate increases and spending cuts while beginning a process to overhaul entitlements and the tax code.

About 80 percent of respondents to a survey from Citigroup Inc. released Nov. 9 expect at least temporary relief from related cuts, expiring tax reductions, or both, at the end of the year. About 75 percent expect only modest progress in the next three months, followed by postponing a resolution for about six months.

Bond Yields

Bond markets have also rallied amid concern that European leaders’ failure to resolve the region’s three-year-old debt crisis will impede global economic growth. The Fed’s unprecedented easing measures, including $2.3 trillion of U.S. government securities purchases, have helped drive down yields, which reached a record low 1.379 percent on July 25.

The U.S. economy will grow 2 percent in 2013, according to the forecasts of 89 economists in a Bloomberg survey. GDP is expected to rise to 2.7 percent in 2014.

The benchmark 10-year note declined 11 basis points to 1.61 percent last week, according to Bloomberg Bond Trader prices. Yields plunged even as the U.S. sold $72 billion in notes and bonds last week. The U.S. bond market was closed yesterday for Veterans’ Day.

Yield Forecasts

Forecasts continue to recede. The 10-year note will trade below 2 percent through March 2013, or 1.9 percent, according to the median prediction of 86 analysts in a Bloomberg News survey. In June, they expected 2.5 percent, down from 2.84 percent in January.

The yield on the benchmark note dropped 25 basis points to 1.61 percent as of Nov. 9, from 1.86 percent on Sept. 21, 2011, when the central bank began a $400 billion round of Operation Twist, a program in which the Fed replaces shorter-term maturities in its holdings with longer-term debt to sustain the economic recovery. It announced a $267 billion extension of the program in June.

Ten-year yields declined two basis points, or 0.02 percentage point, to 1.59 percent at 3:39 p.m. New York time after falling to 1.57 percent, the least since Sept. 5.

Ten-year notes have “a bid based upon the Bernanke expectation for easy money as far as the eye can see,” Pacific Investment Management Co.’s Bill Gross, who runs the world’s biggest bond fund, said Nov. 9 on Bloomberg Television’s “Street Smart” with Trish Regan. As for the fiscal cliff, “finding that middle ground will be very difficult,” said Gross, founder and co-chief investment officer at the Newport Beach, California-based company.

Pimco’s Holdings

Gross raised the proportion of U.S. government and Treasury debt at Pimco’s $281 billion Total Return Fund to 24 percent of assets last month, from 20 percent in September, according to a report on the company’s website. Mortgages remained the fund’s largest holding at 47 percent, down from 49 percent a month earlier.

Demand for government debt has increased as investors offered a record $3.17 for each dollar of the $1.79 trillion in notes and bonds sold by the U.S. Treasury this year, before last week’s sales, compared with $3.04 in 2011 and $2.99 in 2010, according to data compiled by Bloomberg.

The premium investors demand on Treasury securities maturing in 10 years or more, narrowed over the past two years when compared with those of non-U.S. government bonds globally. The premium narrowed to seven basis points as of Nov. 9, according to Bank of America Merrill Lynch Indexes, indicating the securities are converging as investors avoid riskier securities. The figure dropped from as high as 104 basis points in February 2011 and 98 basis points in April 2010.

Dealers’ View

Even dealers who anticipate a budget deal say the market isn’t yet pricing that in. Ten-year Treasuries imply the economy will tip into recession in the next year, Terry Belton, global head of fixed-income and foreign-exchange research at primary dealer JPMorgan Chase & Co., said in a video on Nov. 5.

“Markets are trading to the full fiscal-cliff really being hit at the end of this year,” Belton said. “Our baseline continues to be that Congress avoids the fiscal cliff.”

Belton said he expects 10-year Treasuries to yield 2 percent by the end of the year.

Fitch Ratings warned on Nov. 7 that the U.S. may be downgraded next year unless lawmakers reach a budget deal and raise the $16.4 trillion debt ceiling in a timely manner before it’s reached early next year, while Moody’s Investors Service said it will wait to see the economic impact should the nation experience a tax and spending shock.

Reduce Deficit

The combination of tax increases and spending cuts “would lead to a sharp reduction in the federal deficit, and so that from a credit perspective is beneficial,” Bart Oosterveld, managing director and head of sovereign risk division at Moody’s in Washington, said Nov. 7 in a telephone interview. “We just don’t know what the economic effects of that are.”

Standard & Poor’s, a unit of McGraw-Hill Cos., stripped the U.S. of its AAA credit rating on Aug. 5, 2011, after months of political wrangling pushed the nation to the deadline for an agreement to lift the debt ceiling. Fitch and Moody’s assign the U.S. their top rankings with negative outlooks.

Markets have repudiated past downgrades. Since the S&P move, Treasuries have returned 7 percent, and 10-year yields are down from 2.56 percent. “It would not be a problem if the U.S. received a downgrade,” Mike Materasso, co-chairman of the fixed-income policy committee at Franklin Templeton Investments, said at the Bloomberg Portfolio Manager Conference Nov. 8.

Tax Cuts

Obama and Congressional Democrats want to let tax cuts expire for individual incomes above $200,000 a year, while Republicans advocate extending them for all levels. The president wants to boost the two top rates from the present 33 percent and 35 percent, to the levels they reached when Bill Clinton left office in 2001 -- 36 percent and 39.6 percent. He also wants higher taxes on capital gains and dividends and a smaller estate tax exemption and higher rate.

The president on Nov. 9 invited congressional leaders to revive bipartisan deficit-reduction negotiations. His chance of success, say Republicans and Democrats, depends on his willingness to build a rapport he has lacked with lawmakers and take a stronger role in steering negotiations.

Boehner, an Ohio Republican, told reporters Nov. 9 that his party wants a “simpler, cleaner, fairer tax code.” He cited ideas Democrats have rejected such as restructuring entitlement programs and relying on revenue generated by economic growth from a tax-code overhaul, with no rate increases.

“I’m optimistic,” Ken Volpert, principal and head of taxable bonds for Valley Forge, Pennsylvania-based Vanguard Group Inc., said of the likelihood that the government will eventually reach a budget compromise. The group is the largest private owner of Treasury securities, with $157 billion.

‘Big Deal’

“Maybe it won’t happen quickly,” Volpert, who manages about $375 billion, said on Nov. 8 in an interview in New York. “It’s a big deal.”

Yields on Treasuries maturing in 10 years that have climbed about 21 basis points since their record low on July 25 signal the market hasn’t priced in the full impact of the potential automatic tax increases and spending cuts, said James Sarni, senior managing partner at Los Angeles-based Payden & Rygel, which manages $75 billion.

“If the market were really convinced we were going to go off the fiscal cliff, I think we’d be flirting with all-time lows,” Sarni said on Nov. 8 in a telephone interview. “People want to believe there’s going to be some improvement in Washington. I’m a little more cynical and believe in the old saying that actions speak louder than words.”

Fed Policy

The Fed has been the main driver of low yields, after buying $2.3 trillion of Treasuries and mortgage-related bonds since 2008 in two rounds of quantitative easing, or QE. The central bank said Oct. 24 it would continue its stimulus measures by purchasing $40 billion of home-loan securities a month until the labor market improves “substantially.”

All 21 primary dealers forecast the central bank will add Treasury purchases to the $40 billion a month in mortgage bonds it’s now buying, after its $667 billion Operation Twist program to extend bond maturities ends, according to a Bloomberg survey conducted in the week ending Oct. 19.

The Fed may stand as the only source of policy support for a U.S. economy burdened by 7.9 percent unemployment. Its third round of stimulus may extend through next year and climb past $1 trillion, said economists at JPMorgan and Pierpont Securities LLC.

“Whatever you hear about a grand bargain is pie in the sky,” Rich Tang, head of sales for North America at Royal Bank of Scotland Group Plc’s RBS Securities unit in Stamford, Connecticut, said on Nov. 7 in a telephone interview. “The market is pessimistic about the ability of Washington to reach an agreement on the fiscal situation.”

To contact the reporters on this story: Susanne Walker in New York at swalker33@bloomberg.net; John Detrixhe in New York at jdetrixhe1@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net

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