Monday, June 20, 2011

For Treasury Bulls, It's All Good

For Treasury Bulls, It's All Good

Even a Potential U.S. Government Debt Default Doesn't Faze Them

By MATT PHILLIPS

Investors have been on hair-triggers in markets around the world, dumping their holdings at the slightest sign of trouble. There is one big exception: U.S. Treasurys.

The U.S. government is several weeks away from the possibility—albeit remote—of a default, yet Treasury prices are rising, pushing yields to their lowest levels of the year. Not only do bond-market investors appear unconcerned about the ongoing debate over raising the debt limit, many see any budget deal as a boost for the market.

Treasury optimists interpret this weekend's golf outing between President Barack Obama and House Speaker John Boehner (R., Ohio) as a positive on the prospects for a deal, says Dan Clifton, head of policy research at Strategas Research Partners.

"While it may sound cheesy, there's dialogue going on and you're going to need that dialogue to seal the final deal," Mr. Clifton said.

The bullish scenario that the Treasury market is pricing in is as follows: The budget talks go down to the wire, but trading remains calm as negotiations muddle toward an eventual deal. Pronouncements from Washington don't show positions hardening ahead of the Aug. 2 deadline set by the Treasury Department. The expected 11th-hour deal not only averts default, it slows the economy by cutting government spending, boosting Treasurys.

"What the market currently believes right now is that there's going to be a resolution of some sort, and we're not going to have to worry about this on Aug. 2," said Jim Caron, global head of interest rates strategy at Morgan Stanley. "We want to know that there's room for agreement. So if anybody takes a hard line on it, the market's going to react to that."

Instead of a possible default, investors, focused on slowing growth in the U.S. and turmoil in Europe, are treating Treasurys as the safe haven they always have been. The yield on the 10-year note finished Friday slightly lower, at 2.944%, down from 3.57% in early April.

Indeed, the bad-news scenario for Treasurys would appear to be an unexpected jump in economic growth. The conventional wisdom is that the end of the Federal Reserve's bond-buying program over the next few weeks will likely add to the economy's weakness, rather than lead to a selloff in Treasurys, which would boost their yield.

To be sure, Treasurys could see some volatility as politicians in Washington fire more salvos over the next few weeks. David Ader, head of government-bond strategy at CRT Capital Group, in Stamford, Conn., says he will be paying particularly close attention to the tone of influential Republicans from the House of Representatives.

He said the bond market wants to see statements from Republicans that show "a more strident or adamant view that, 'We will not allow the U.S. to go into default, but we want to get something for it.' "

It is unlikely, however, that that is the only message that will be delivered to the bond market. "We're going to have that big fight," said Mr. Clifton, of Strategas Research. "A lot of it is going to be noise, but it just creates that background of volatility as it goes into those final negotiations."

All this isn't to say there is no indication of concern. Trading in credit-default swaps on U.S. debt—insurance-like contracts that pay off in the event of a default—has picked up. And prices for shorter-term versions of such protection have risen, indicating that the concern is about the debt-ceiling debate, not longer-term fiscal issues.

Some big investors in Treasurys are also worried. Bill Gross of Pacific Investment Management Co. dumped his Treasury holdings several months ago, and over the weekend a top aide to Russian President Dmitry Medvedev said the country will continue to reduce its Treasury holdings, citing the budget impasse and slow growth.

China, the biggest foreign holder of Treasurys, boosted its holdings of Treasurys in April after five months of reducing its stake, and overall foreigners were buyers that month.

Treasury bulls see any budget deal, which would likely include spending cuts, as a boost to the market because the cuts would be another headwind for the economy and, some argue, another reason to own Treasurys.

"I believe that spending cuts will have disproportionate effect on growth this time around," said Priya Misra, head of U.S. interest-rates strategy research at Bank of America Merrill Lynch, adding, "Treasurys are not necessarily the worst investment out there, if you think that the economy is weakening."

Write to Matt Phillips at matt.phillips@wsj.com

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