Treasuries face risks, but sustained retreat seen unlikely
* Subdued growth outlook would limit potential post-QE3 sell-off * Fed guidance curbs inclination to price in higher rates * Immediate focus on August U.S. payrolls By Ellen Freilich NEW YORK, Sept 6 (Reuters) - The U.S. government bond market could be in for a rough ride in the coming weeks, especially if Friday's jobs report shows surprising strength, but it will take much more to unravel the three-decade's-long rally in Treasuries. The Federal Reserve's policy meeting next week presents an immediate risk. Whether the U.S. central bank decides to engage in a new round of bond-buying stimulus strongly hinges on the government's closely watched monthly jobs report on Friday, strategists said. The European Central Bank's announcement on Thursday of plans aimed at halting the spread of the euro zone debt crisis dimmed the safe-haven allure of Treasuries, while an unexpectedly strong batch of U.S. jobs and service-sector data contributed to a modest selloff. With unemployment still above 8 percent, nothing suggests economic growth is approaching escape velocity, but a surprisingly strong August jobs report could cause some investors to wonder when that might start to change. "Treasuries are at a bit of a crossroads at the moment," said Zach Pandl, interest-rate strategist at Columbia Management, a Boston-based investment firm with $331 billion in assets under management. However, until there is a sustainable change toward a stronger labor market and other improvements in economic data, investors will expect the Fed to remain active in pinning down long-term borrowing rates and possibly launching another round of unconventional easing. Will the Treasury market be disappointed if the Fed does not announce another phase of quantitative easing next week? Again, it depends on the payrolls report, analysts said. "The Treasury market could react negatively if the Federal Open Market Committee doesn't signal a strong inclination to doing more easing at the next meeting," said Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management in Menomonee Falls, Wisconsin. "The 10-year Treasury is at 1.68 percent, but it could begin a rapid move to 2.1 percent, which is where it was last year at this time. The ECB's aggressive stance has driven Treasury yields higher and if the Fed doesn't ease, that could be another blow to the Treasury market." In the first two chapters of quantitative easing, Treasury yields eased in anticipation of the Fed action and on the days of the actual announcements - Nov. 25, 2008, and Nov. 3, 2010 - and rose afterward. Pandl said that dynamic may have changed now that the Fed has employed other policy tools, such as its long-term horizon in its promise to keep interest rates low. The Fed's first use of forward guidance on short-term interest rates came in August 2011. The following month it announced a program known as Operation Twist, in which it sells shorter-dated securities from its portfolio and uses the proceeds to buy longer-dated Treasuries to drive down long-term lower interest rates If the Fed does announce bond purchases next week, yields could rise, but the rise could be from levels that are down from those seen on the eve of the August U.S. payrolls report. That's because a Fed announcement could be predicated on a weak payrolls report which, by itself, would be bullish for Treasuries, causing prices to rise and yields to ease, said Kevin Flanagan, chief fixed income strategist at Morgan Stanley Smith Barney with $1.7 trillion in assets under management. "For the Fed to give you QE3 next week, it would probably be because we had much lower-than-expected job growth and probably an increase in the unemployment rate, so the market might start to discount a potential QE3 announcement before it actually occurs," he said. James Sarni, managing principal at Los Angeles-based Payden & Rygel, with more than $70 billion in assets under management, said a selloff in Treasuries after a Fed announcement was possible, but would likely be short-lived. "It's equally likely we could see a big rally," he said. "A weaker-than-expected payrolls number could prompt a rally." If the Fed does hold off on more stimulus, bonds might suffer as a result, but this too could be a double-edged sword. After several false dawns, belief in a quick turnaround for the economy is harder to come by now than a few years ago. Any disappointment at the lack of a new program could also hit stocks, a move that would eventually support bonds. "The key is that as the economy recovers, interest rates would have a natural tendency to rise, but we don't see a violent selloff because the Fed's forward guidance anchors rate expectations and because people's expectations are that growth will be subdued," Pandl said. "After three years of head-fakes around growth potentially taking off, there is a great deal of skepticism about the ability of the U.S. economy to grow at an above-trend pace."
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