Outlook bright due to euro crisis, likelihood of Fed steps

Benchmark U.S. Treasury yields held within striking distance of their lowest levels in nearly 60 years on Monday as expectations grew that the Federal Reserve will take more steps to shore up a sputtering economy at a review this week.

Portfolio managers and hedge funds have been forced to cover back short Treasury bets as the worsening U.S. economic outlook increased pressure on the Fed to undertake more quantitative easing measures.

A slew of poor data culminating in weak August payrolls numbers earlier this month and a steady drip of negative news from the euro zone have also burnished the safe-haven appeal of U.S. Treasuries and pushed yields close to record lows.

Hopes have grown the Fed would talk about or at least hint at expanding the maturity base of its bond holdings by buying longer-dated U.S. debt in a campaign called "Operation Twist" at a two-day meeting that ends on Wednesday.

But after the Fed took short-term interest rates to near zero and bloated its balance sheet with bond purchases that have topped $2 trillion, analysts said any incremental step would be a nuanced one.

In a note, strategists at Wrightson ICAP predicted the Fed would do just enough to keep market expectations of a future maturity-extension program alive without committing itself to large-scale operations right away.

To be sure, some market participants believe that such expectations are already reflected in the market, partially because of the fumbling efforts by euro zone policymakers to stem a spreading debt crisis.

Between late July and earlier this month, ten-year yields dropped by more than 100 basis points to 1.91 percent, their lowest levels in nearly 60 years, before paring some of the drop to yield 2.06 percent on Monday.

More Gains Eyed

Spreads between ten and two-year debt held around 187 bps on Monday, widening from a 2-1/2 year low of 174 bps hit last week.

But with no immediate solution to the euro zone debt crisis in view, traders say Treasuries should be well bid in the near term, extending their strong performance this year and encouraging more funds to shift into safe-haven bets for now.

The cancellation of a visit by Greek Prime Minister George Papandreou to the United States in order to chair an emergency cabinet meeting at home, and a regional election defeat for German Chancellor Angela Merkel, added to a sense of worsening crisis.

From a total returns perspective, Treasuries have delivered nearly eight percent so far this year, according to Bank of America Merrill Lynch Treasury Master Indexes.

In contrast, JP Morgan's GBI-EM local currency bond index has gained more than 5 percent this year compared to the MSCI index of Asia shares ex-Japan which is down 15 percent in the same period.

That has forced fund managers like Bill Gross, the manager of the world's largest bond fund PIMCO, to increase exposure to Treasuries dramatically in August after holding a short position earlier this year.

Wee-Khoon Chong, a strategist at Societe Generale, believes the growing risks from the euro zone crisis would offset any disappointment from a muted Fed action for now and keep demand for Treasuries intact.

The French bank expects ten-year yields to test 1.75 percent by the first quarter of 2012.

[Source: By Saikat Chatterjee, Reuters, Hong Kong, 19Sep11]

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