Bonds drop, but debt deal adds to economy worries

HONG KONG Mon Aug 1, 2011 1:50am EDT

HONG KONG (Reuters) - U.S. Treasury futures fell from an eight-month high on Monday after Republicans and Democrats thrashed out a compromise on cutting the budget deficit and raising the debt ceiling, although the slash in spending is seen adding to the headwinds facing an already weak economy.

Market players were now waiting to see if both houses of Congress would pass the deal and send to President Obama for his signature before Tuesday's deadline for when the Treasury would default, though comments from lawmakers suggested the deal would pass.

Asian shares jumped on the news, with the broad MSCI regional index gaining nearly 2 percent and S&P e-mini futures up 1.5 percent on a relief rally. Other safe havens, such as the Swiss franc and gold, also lost ground.

The debt agreement -- a two-step process to cut $2.4 trillion of the next 10 years -- overshadowed China's official PMI showing factory growth slipping to a 28-month low in July.

The focus is now shifting to the economy's troubles after second-quarter GDP data last week showed the expansion much weaker than expected over the past few quarters and coming out of the crisis, raising fears that growth is closer to stall speed.

The surprisingly grim GDP data sparked a sharp drop in Treasury yields along the curve, on top of the worries about the debt ceiling showdown and a potential delay in the Treasury's quarter refunding auctions set to be announced this week.

Friday's drop in yields suggested that investors remained more fixed on the economic outlook, and even a cut in the United States' top AAA rating would reverse the drop in yields.

With many hedge funds and institutional portfolio managers short or only keeping light positions in Treasuries, investors may need to rush back into the bond market, traders said.

"People are not invested," said the head trader at one U.S. primary dealer in Tokyo. "We could rally into payrolls, and for a lot of investors it would be hard to stomach that kind of a rally."

The ISM manufacturing report later in the day is expected to show growth cooling slightly, with the Reuters consensus forecast for a reading of 54.9 in July compared with 55.3 last month. The data comes before the monthly jobs report on Friday.

September T-note futures fell 7.5/32 to 125-14.5/32 on volume of about 60,000 lots, with trade dying down after a burst of selling when Obama announced the deal.

Five-year Treasuries lost 8/32 to yield 1.399 percent, up about 5 basis points from late U.S. trade on Friday when yields slid to an eight-month low of 1.344 percent.

Two-year yields were little changed at 0.379 percent, while 10-year yields rose 5 bps to 2.839 percent.

MUTED RESPONSE

"The bond market's response has been relatively limited if for no other reason than we still have the backdrop of very slow economic growth particularly for this stage in the business cycle," said Ian Lyngen, a bond strategist at CRT Capital Group in Stamford, Connecticut.

Traders said that the fading risk of a default was also likely to help calm the Treasury repo market where banks and funds had increasingly become nervous about the fallout on one of the key funding arteries in U.S. financial markets.

By Friday, overnight Treasury repo rates had jumped to 0.33 percent from just 0.06 percent at the start of the week.

Swap spreads also reflected some of the perceived reduction in risk. Two-year spreads, a proxy of counterparty banking risk, shrank to 21 bps from near 23 bps late on Friday.

Friday's drop in yields showed that many investors still scramble for Treasuries as a safe-haven in times of market stress of turmoil, even when the issue at hand is a Treasury default.

The weekend debt deal negotiated in Washington did not answer many of the big questions facing the long term U.S. budget outlook, including tax collection and entitlement spending -- still leaving the U.S. credit rating on the hook.

"A ratings cut, say to AA, will not itself cause a big problem for existing holders including central banks and sovereign wealth funds and there is no perfect alternative (to U.S. Treasury debt)," said Hong Taeg-ki, head of the reserve management group at the Bank of Korea, the central bank.

"Central banks will continue their efforts to diversify their reserve assets but they will not be able to quicken the pace of diversification only because of (a possible ratings cut in the U.S.)."

(Additional reporting by Burton Frierson in New York; Editing by Ramya Venugopal)

Comments (0)
This discussion is now closed. We welcome comments on our articles for a limited period after their publication.