--Risk of tax cut expiration, spending cut at turn of year

--Uncertainty over fiscal drag to support Treasury bonds

--Fed might be pressured to do QE3 should growth falter

 
   By Min Zeng 
   Of DOW JONES NEWSWIRES 
 

NEW YORK (Dow Jones)--Treasury bond bears beware. A potential U.S. "fiscal cliff" at the turn of the year could impose another lid on any marked rise in yields.

The term refers to a major fiscal belt-tightening that would come on Jan. 1, 2013 if Congress doesn't act to further postpone or reduce a host of scheduled tax increases and spending cuts. Some economists warn that this would place a significant drag on an economy still struggling to expand at a robust pace and that a recession can't be ruled out.

With the presidential elections looming in November, investors are concerned politicians lack the will to tackle the issues before the end of the year. That wouldn't sit well with investors already stung by the ongoing sovereign-debt crisis in the euro zone. Some disappointing U.S. data in recent weeks have gotten investors nervous about the strength of the economic recovery.

A more-optimistic view holds that the "lame duck" Congress that will exist between the Nov. 6 elections and the end of the year will offer a rare, if narrow and tricky, window of opportunity for divided lawmakers to hatch a compromise deal that converts the economic threat into a more-viable plan that both promotes short-term growth and restores long-term fiscal health.

Any severe fiscal blow to the economy could push the Federal Reserve to add new stimulus to the economy, though officials aren't signaling a willingness to do more. That may be because they want to pressure the federal government into action, but is is also because of rising concerns that an additional infusion of cash into the economy could fuel a longer-term run-up in consumer prices.

Treasury bonds are likely to continue to draw inflows from investors who worry about such uncertainties. Even with yields, which move inversely to prices and are trading near historic lows, money has flowed into the market this week as concerns have increased about a revival of financial stress in the euro zone. Yields are likely to stay low until the economy shows a sustainable and robust pace of recovery, investors and analysts have said.

"The fiscal cliff has the effect of reducing economic growth, being a major hurdle for risky assets and making riskless assets like Treasurys more attractive," said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading in New York at Deutsche Bank's private-wealth-management unit.

Worries about the fiscal drag recently pushed Pollack to revise down his forecast on the 10-year yield for the end of this year. He now sees the end-December yield at 2.25%, down from a previously predicted 2.75%. He added that the 10-year yield, which was trading at 1.886% Thursday, could end the year at 2% or even slip to 1.75% if the magnitude of the fiscal cliff is large enough.

One component of the coming austerity crunch comes from the expiration of the so-called Bush tax cuts instituted in 2001 and the more-recent Social Security payroll tax holiday. The termination of an extended unemployment-benefit program and other business incentives add to their effect. Meanwhile, automatic spending cuts mandated by the awkward compromise that arose out of last year's debt-ceiling deal between bitterly divided Republican and Democrat lawmakers are also on tap.

Economists at Morgan Stanley warn the fiscal tightening, if all of it is to go through, could amount to 5% of U.S. gross domestic product. With U.S. GDP growth running at about 2%, this would result in the economy slipping into a recession. That would lend support to Treasurys.

If Democrats and the Republicans come up with a comprehensive, growth-promoting deal, investors could dump Treasury bonds and flock to stocks. But few investors cling to such hopes. A more-likely outcome is some kind of compromise that limits the blow to the economy but fails to totally eliminate a destructive fiscal drag.

Since members of neither party seem prepared to compromise on their respective positions before the elections--with Republicans opposed to tax increase, and Democrats to cuts in long-term entitlements--it will all likely come down to a flurry of deal-making in the lame-duck period in November and December. If President Barack Obama loses to his Republican rival and himself becomes a lame duck, that could complicate matters further, said Rex Macey, chief investment officer at Wilmington Trust Investment Advisors.

The fiscal cliff may also put the onus on the Fed to act, which would in turn put an anchor on Treasury yields. That is despite that the central bank has telegraphed a completion to its "Operation Twist" stimulus program by the end of June, through which the Fed seeks to push down long-dated interest rates by swapping short-term bonds in its portfolio for longer-dated instruments.

Steven Major, global head of fixed-income research at HSBC Holdings, noted recent clues from Fed Chairman Ben Bernanke that he believes it would be more useful for the government not to tighten fiscal policy than for the Fed to do more bond-buying, also known as quantitative easing.

But if the economy falters again, the Fed may have no choice. "With a weak economy, and in the absence of anything else the Fed will act again," either with an extension of Operation Twist or a new bond-buying program, Major said.

(Min Zeng writes about global fixed income and currency markets for Dow Jones Newswires. He can be reached at 212-416-2229 or via email at: min.zeng@dowjones.com; @djfxtrader)

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(END) Dow Jones Newswires

May 10, 2012 15:07 ET (19:07 GMT)

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