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Analysis: Shutdown, default threat elevates appeal of U.S. Treasuries

By Richard Leong

NEW YORK (Reuters) - Government shutdown. Federal default. These looming political threats to the U.S. economy might scare investors to buy more U.S. Treasuries in the coming days as they seek a shelter for their cash.

While a protracted government shutdown, and particularly a default, could harm to the image of Uncle Sam's debt, its safe-haven appeal looks unchallenged in the short term.

Worried about rising chances that federal workers and contractors won't get paid if much of the government shuts down on October 1 amid a political standoff in Washington, investors are expected to go by the conventional crisis playbook - dumping assets perceived to be higher-risk and rushing into those seen as lower risk.

An extended shutdown, which would include furloughs and temporary unpaid leave for many government employees, would have a direct impact on businesses who rely on government contracts or spending by government employees. It could also lead to delays in spending on big-ticket items by companies and consumers as confidence takes a hit.

That could all harm economic growth and make it less likely that the Federal Reserve will curb its stimulus program through bond buying, further supporting prices of government debt.

Congress must also raise the federal borrowing authority by October 17 - when the government is expected to exhaust its $16.7 trillion debt limit.

Failure to do so could threaten a debt default but many analysts think the government would slash spending before declining to pay its creditors, leaving Treasuries relatively unscathed, at least initially.

Analysts said a risk-aversion move could push benchmark yields on 10-year notes below 2.50 percent, more than 0.50 of a percentage point below the two-year high above 3 percent set in early September. Late on Friday they were trading at about 2.63 percent.

"It's paradoxical that a government shutdown or hitting the debt ceiling is good for Treasuries, but you most likely would see a flight-to-safety into Treasuries," said Bill Cheney, chief economist at John Hancock Financial Services in Boston.

INVESTOR CONFIDENCE

Any fears about a protracted government shutdown haven't been reflected in recent trading. This month, Treasuries are likely to post their first gain in five months as the sector recovered from its summer swoon, sparked by the Federal Reserve decision last week to maintain its bond purchase program.

Growing demand for some Treasury obligations that mature before the October 17 debt limit deadline knocked their interest rates to below zero this week. A month ago, they traded at 0.02 percent.

The yields on benchmark 10-year Treasuries have already fallen to their lowest levels in six weeks partly on safe-haven bids on bets about a possible government shutdown next week.

Still, a long-lasting government shutdown, or, even worse, a default, could harm the Treasuries market.

"You don't want to damage investor confidence in U.S. Treasuries," said Craig Dismuke, chief economic strategist with Vining Sparks in Memphis, Tennessee. "If there is a flight-to-safety, it would a temporary one."

Ironically, the wrangling between President Barack Obama and Republican lawmakers over the budget, the debt ceiling and the Affordable Care Act - also known as Obamacare - was renewed at a time when the U.S. fiscal picture has improved this year.

Higher tax receipts, even in this sluggish recovery, have helped lower the federal deficit and reduced the government's borrowing needs.

PAST LESSONS

Washington last shuttered government offices and stopped paying workers for five days in November 1995 and then from mid-December 1995 to early January 1996.

The yield on the 10-year Treasury notes ended that year at 5.76 percent, down from 7.88 percent at the beginning of the year. The yield had begun falling earlier that summer after the Fed started cutting interest rates in July.

More than 15 years later, under the threat of a federal default, the 10-year yield has fallen 0.6 percentage point from just above 3 percent in three weeks during late July to early August of 2011, when Republican lawmakers and President Barack Obama were also bickering over raising the debt ceiling.

In the derivatives market back then, traders ratcheted up their bets on a U.S. default. The price of thinly-traded credit default swap contracts, which might have paid out if the U.S. government missed its debt payments for an extended period, jumped to 62 basis points, which was the highest since the worst days of the global credit crunch, according to data firm Markit.

This meant an investor would have paid 62,000 euros a year to insure 10 million euros worth of Treasuries against a default within a five-year period. The contract is denominated in euros to offset the impact of a default on the U.S. currency.

On Friday, the price on the five-year CDS on U.S. Treasuries was nearly 32 basis points, the highest since May.

It is difficult to predict what might transpire the coming days.

"Looking at history, there is not a clear pattern," said Cheney at John Hancock.

The 1995 government shutdowns barely interrupted a Standard & Poor's 500 index's <.SPX> winning streak. It ended up 34 percent that year.

In contrast, the S&P tumbled 14 percent in the summer of 2011 during the first debt ceiling fight between Obama and the Republicans and following Standard & Poor's stripping of the United States' AAA-rating. Investors stampeded into Treasuries from stocks.

While many still expect that the White House and Republican leaders will come up with temporary fixes to avert a government shutdown and a default, analysts said there is some nervousness given that political leaders have remained far apart.

"We are conditioned for an 11th hour deal, but you can't take anything for granted," said Eric Green, global head of rates, currency and commodity research at TD Securities in New York.

If Washington were able to keep the government running and paying its bills, the 10-year yield will likely rise back to around 2.75 to 2.80 percent. It would also allow Wall Street to focus on whether the economy is showing any signs of picking up steam and the timing of the Fed's bond buying pullback, analysts said.

"The Fed tapering is way more important than all of this," Cheney said.

(Reporting by Richard Leong; Editing by Martin Howell and Tim Dobbyn)

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