Bonds Join Stocks Falling in Markets Overwhelmed by Debate

Treasuries Join Stocks Dropping in Markets Overwhelmed by U.
Traders work on the floor of the New York Stock Exchange July 28, 2011. Photographer: Richard Drew/AP

Stocks and Treasuries are moving in tandem twice as often as they normally do, a sign investors are growing convinced the U.S. will lose its AAA credit rating and that an impasse among lawmakers may spur losses in both markets.

The Standard & Poor’s 500 Index has risen or fallen together with 10-year Treasury notes 80 percent of the time in the last 10 days, compared with the average since 2000 of 41 percent, according to data compiled by Bloomberg. The benchmark index for American shares lost 2 percent yesterday, the most since June 1, and the 10-year bond fell, driving its yield up three basis points to 2.98 percent.

Equities and government bonds are reversing their historical relationship because a downgrade and the possibility of default by the U.S. government would put principal payments at risk and curb economic growth that has helped send the S&P 500 up 93 percent since March 2009. Conviction that lawmakers will fail sent rates on bills due next month to the highest level since March 31, data compiled by Bloomberg show.

“The politicians should learn from this that they shouldn’t wait until we have our backs against the wall,” Donald Selkin, New York-based chief market strategist at National Securities Corp., said in a telephone interview. Selkin, a 35-year Wall Street veteran, helps manage about $3 billion. “It’s very irresponsible because it can affect the economy and jobs. They’re putting us in a situation where we could have another financial meltdown.”

Rising Ratio

While stock and bond prices have moved in tandem four days out of every 10 during the past decade, periods when the pattern holds for more than two days in a row are rare, according to data compiled by Bloomberg. Since 2000, the price correlation has occurred on eight days in any 10-day stretch less than 1 percent of the time, the data show.

“When the risk-free asset has risk in it, it creates a new investment environment,” Stephen Wood, who helps oversee $163 billion as the New York-based chief market strategist for Russell Investments, said of Treasuries in a telephone interview. “It’s an indicator of uncertainty. The market doesn’t have the ability to discriminate between asset classes, sectors or industries.”

The House of Representatives planned to vote today on a debt-limit increase proposal that confronts unified Democratic opposition in the Senate, setting the stage for a congressional showdown to avert a U.S. default.

Boehner Wins Support

House Speaker John Boehner of Ohio gained support among fellow Republicans for his plan to raise the debt ceiling after reworking the legislation to cut $917 billion over 10 years, more than his original approach. All 51 Senate Democrats and two independents signed a letter yesterday pledging to oppose the measure.

Concern the U.S. credit rating will fall sent the S&P 500 down 3 percent through yesterday since July 22, the day Boehner walked out of negotiation with Barack Obama, saying the president had “moved the goal posts” on raising revenue. The decline trimmed the index’s advance for 2011 to 3.8 percent from as much as 8.4 percent on April 29, when it reached an almost three-year high, according to data compiled by Bloomberg.

Rates on Treasury bills set to mature just after the Aug. 2 debt-ceiling deadline rose to 0.112 percent, the highest level in five months. Five-year notes sold at auction yesterday drew a yield of 1.58 percent, compared with the average forecast of 1.547 percent in a Bloomberg News survey of nine Federal Reserve primary dealers.

‘Major Recession’

“It’s happening because we’re looking at a deficit that’s beyond anything seen before in history, except the depths of the Second World War,” Rob Arnott, who helps oversee $75 billion as founder of Research Affiliates LLC in Newport Beach, California, said in a telephone interview.

“If they take spending off the table quickly enough, it creates a major recession,” he said. “What the rating agencies are pointing out is if you don’t take spending off the table, you eventually hit a Greek-style wall and they can’t allow that.”

Assuming no measures are taken to reduce the deficit, a 1 percentage point increase in long-term borrowing costs and a 0.18 percent decline in annual GDP growth would lead to debt increasing to 93.4 percent of GDP in 2020, according to Bloomberg Government estimates. Greek public debt was 143 percent of gross domestic product as of Dec. 31.

Today’s Trading

The benchmark 10-year Treasury note rallied today, sending its yield down three basis points to 2.95 percent at 4:43 p.m. in New York, below the average of 4.05 percent over the last decade and less than the average of 5.48 percent when the U.S. was running budget surpluses between 1998 and 2001. The S&P 500 slumped 0.3 percent to 1,300.67, its fourth straight loss.

The U.S. government may lose its AAA credit rating even if lawmakers reach a plan to avoid a default, Mohamed A. El-Erian, whose Pacific Investment Management Co. is the world’s largest manager of bond funds, said in an e-mail to Bloomberg News on July 24. BlackRock Inc., Franklin Templeton Investments, Loomis Sayles & Co. and Western Asset Management have also said that the nation faces the loss of its top-level grade.

The U.S. will run out of options to prevent a default unless the $14.3 trillion borrowing limit is increased by Aug. 2, Treasury Secretary Timothy F. Geithner has said.

S&P, which has given the U.S. a top AAA ranking since 1941, said on July 14 that the chance of a downgrade within three months is 50 percent, and a reduction may occur as soon as August if there isn’t a “credible” plan to reduce the nation’s deficit.

‘Mob Behavior’

Losses would worsen after a downgrade, according to John Milne of JKMilne Asset Management, who oversees about $1.8 billion as chief executive officer in Fort Myers, Florida. Vigilantes, a term coined by economist Ed Yardeni in 1983 for investors who protest fiscal policies by dumping bonds, may surface if lawmakers fail to head off a ratings cut, he said.

“If there is a vigilante-type or mob behavior, it’s going to happen post-downgrade, and that’s when the market will extract some pain,” Milne said. “When vigilantes come out, you’ll see extraordinary moves in the market.”

At a White House briefing yesterday, press secretary Jay Carney was asked if it would help speed action in Congress “if the markets indicated that there’s pending catastrophe.”

“No, we do not hope for or want in any way negative consequences in order to force action,” he said. “We just want Congress to take action. We want our economy to grow, our markets to grow, firms to hire.”

Borrowing Costs

A decision to cut the government’s credit rating would likely increase Treasury rates by 60 to 70 basis points over the “medium term,” raising the nation’s borrowing costs by $100 billion a year, Terry Belton, global head of fixed-income strategy at JPMorgan Chase & Co., said on a July 26 conference call hosted by the Securities Industry and Financial Markets Association. It could also hurt the rest of the economy by increasing the cost of mortgages, auto loans and other types of lending tied to the interest rates paid on Treasuries.

The U.S. unemployment rate rose for a third straight month in June to 9.2 percent, pointing to an economy lacking momentum entering the second half of the year. Employers added 18,000 workers to payrolls, the fewest in nine months and less than the most pessimistic forecast in a Bloomberg News survey of economists.

Earnings Season

The dispute over plans to cut the U.S. federal deficit has stolen investor attention away from an earnings season that has produced higher-than-estimated results at 78 percent of S&P 500 companies that reported since July 11. Shares of industrial companies helped lead declines yesterday after a Commerce Department report showed durable goods orders fell 2.1 percent.

Deadlines for Congress are an invention aimed at forcing through tax increases, according to Bill Huizenga, a first-term Republican representative from western Michigan. Boehner said July 24 that a budget agreement was needed to calm Asian financial markets. After no accord was reached, the MSCI Asia-Pacific Index lost 1 percent the next day before erasing the drop in the next session, data compiled by Bloomberg show.

“They’re trying to create some panic in the marketplace which simply shouldn’t be there,” Huizenga told reporters after a meeting of lawmakers at the Capitol. “This ‘Armageddon happens at midnight Aug. 3’ is not simply the case, is not true,” he said. “There are some things that give us a little breathing room, not a whole lot of time but a little breathing room.”

S&P Analyst

David Beers, the London-based managing director of sovereign credit ratings at S&P, said in an interview this week that he didn’t know when a committee would decide whether to cut the level. U.S. lawmakers are unlikely to find reaching a compromise gets any easier with time, he said.

“For us, the issue is not the debt limit -- it’s the underlying fiscal dynamics,” said Beers, who has been rating governments for the company for 20 years. “It’s not obvious to us that this political divide that is proving so difficult to bridge is going to be any more bridgeable three months from now or six months from now or a year from now.”

While yields on 10-year notes suggest bond investors don’t expect a default, government efforts to prevent one by reducing spending could still harm the economy, according to Anthony Valeri, market strategist in San Diego at LPL Financial, which oversees $340 billion.

“The government is losing credibility,” Valeri said. “It reflects the uncertainty around the situation. The closer we get to Aug. 2 without a resolution, the greater the risks.”

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