Bumpy Ride Likely for Treasurys

Bumpy Ride Likely for Treasurys

By CYNTHIA LIN

NEW YORK—As the clock ticks down on a deal to raise the debt ceiling, the partisan bickering and floating of trial balloons are pricking Treasury bond holders' nerves.

For months, Treasurys investors largely brushed off any notion that the world's largest economy would miss an interest payment and face losing its top triple-A rating. The euro-zone debt crisis and fragile U.S. economy consumed much of the attention, fueling a three-month run-up in Treasury prices as investors sought financial safety.

But prospects of a technical default are getting hard to ignore without a signed agreement as the calendar heads toward the Treasury Department's Aug. 2 deadline, when the U.S. is supposed to run out of money to pay all of its bills.

Word of a $1.5 trillion agreement on spending cuts between Republicans and Democrats sparked a selloff in Treasurys Thursday. It wasn't so much a reaction of hope, but rather frustration, analysts say, since stocks ended lower alongside the drop in Treasury prices. Some say the figure was disappointing, falling short of the $4 trillion in budget savings needed and $2 trillion from a Republican proposal last weekend.

For the week, Treasury prices rose, pushing the benchmark 10-year yield to 2.910% on Friday, from 3.014% a week earlier.

Other plans have emerged, such as Minority Leader Mitch McConnell's arrangement to allow the president to lift the debt ceiling on his own, and House Majority Leader Eric Cantor's "Cut, Cap and Balance" approach.

"The market doesn't know what to react to because there's such a cacophony out of Washington," said Ward McCarthy, chief financial economist at Jefferies. "Until they've sign on the dotted line, no one is going to believe they've agreed on anything."

Throw ratings companies in the mix, and the consequences of a missed payment, however technical, looms larger. Standard & Poor's said Friday there is a chance it will downgrade the U.S. even before a missed debt payment if it sees the probability of a default rising further between now and Aug. 4, when S&P said an interest payment is due. Moody's put the U.S. on negative watch Wednesday, following through on a promise made last month if it felt there was a lack of progress in Washington.

While it is hard to imagine a world where U.S. government debt isn't the global investment safe haven, investors are getting increasingly anxious.

The 30-year bond, where owners stand to lose the most if the value or credibility of U.S. debt is in question, has underperformed, with its yield rising faster than those of shorter-dated notes.

Justin Lederer, senior strategist at Cantor Fitzgerald, said he expects "extreme volatility" in the Treasury market to persist as the budget debate drags on. "Across the market, it's a tug of war back and forth ... and on the long end, there's a fear of what the long-term outlook for the economy is."

For the week ended Wednesday, global fund tracker EPFR found that there was a notable turn within U.S. bond-fund inflows toward those mandated to invest in intermediate five- to eight-year debt. "There was not much interest in longer-term" U.S. debt, said EPFR analyst Cameron Brandt. "I would say it is tied to the uncertain fiscal monetary outlook for the U.S."

Some Asian nations, among the biggest foreign owners of U.S. debt, have been quietly wringing their hands over the battle on Capitol Hill. Officials and analysts there have voiced concerns but said they have few alternatives for parking their cash.

But signs of anxiety reflected in the markets remain contained, and U.S. analysts say a default at home could be very different from any of those abroad.

"A ratings downgrade would be about politics, not about the U.S.'s ability to pay. Markets do understand that," said Ira Jersey, interest-rate strategist at Credit Suisse.

In fact, if no agreement is reached by Aug. 2, Kevin Giddis, president of fixed-income capital markets at Morgan Keegan, says that Treasurys could even gain in that scenario. "As counterintuitive as this may sound, my guess is that Treasurys will initially rally on the news," Mr. Giddis said, citing how investors "instinctively" head to U.S. government debt while in risk-off mode.

Write to Cynthia Lin at cynthia.lin@dowjones.com