Bond market prices Fed out – but just wait ‘til the debt ceiling

January 7, 2013

U.S. government bonds sold off last week following December Fed meeting minutes indicating growing doubts inside the central bank about the effectiveness of quantitative easing. Yields on benchmark 10-year notes hit an eight month high of 1.975 percent on Friday, in part as investors priced out some of the Fed asset purchases traders had been counting towards the end of 2013.

Other forces were also at work. Markets were relieved that the ‘fiscal cliff’-related expiration of Bush-era tax cuts had been circumvented, and encouraged by some moderately better U.S.economic data. The S&P 500 closed the first week of the year at its highest in five years.

Still, as has erroneously been the case in recent years, talk of a bond bubble resurfaced.

Richmond Fed President Jeffrey Lacker was asked about it at a bankers’ conference in Baltimore. He answered:

It’s virtually impossible to say something is a bubble in real time. I do think markets at times overshoot, and that could be possible in the long-term debt market.

Writes Evariste Lefeuvre, economist at Natixis North America in a research note:

 It is clearly too early to call for a return of the ‘bond vigilantes.’ Yet, better growth prospects combined with growing uncertainty on the conduct of monetary policy and the expansion of central banks’ balance sheets, suggests that the potential for higher 10-year U.S. rates is significant in 2013.

At the same time, however, one needn’t look very far to spot a number of forces that might keep U.S. borrowing costs low for the foreseeable future. Fed asset purchases are perhaps the most obvious. Even if internal appetite for them is waning, the central bank has tied a cessation of stimulus to substantial improvement in the labor market outlook, which still looks a distant prospect.

More immediate threats to economic stability will also keep a floor under the Treasury market. The next bond rally could emerge from expected gridlock over the U.S. debt ceiling, which will now be hit in February following emergency steps from Treasury.

George Goncalves of Nomura advised clients:

We believe with the debt ceiling approaching and both parties still divided on spending cuts, the drama will lead us to another mini-rally.

Ironically, another downgrade of U.S. sovereign debt would probably bolster appetite for U.S. government bonds. That’s because they are seen as safe-havens from global turbulence – even when the United States itself is the source of the instability.

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