Why Treasurys may be this quarter’s best bet

Bonds
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The market widely expects Treasury prices to fall as Federal Reserve tightening inches closer, but contrarian bets that bonds will continue to march higher are emerging.

"We expect high uncertainty to make the fourth quarter a risk-off one," Tim Condon, chief economist for Asia at ING, said in a note Tuesday. "Long-dated U.S. Treasurys and their proxies [investment-grade-rated bonds] are our top picks to perform in the fourth quarter," he said, citing expectations investors will seek safe-haven plays.

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Condon sees risks from both the Federal Reserve's likely moves toward tightening policy and from China's economy.

"With the Fed scheduled to complete tapering on October 30 questions about the lift-off will become more urgent," Condon said, citing concerns over when and how high interest rates will rise. "The Fed wants to be transparent and pin down expectations, but we also think prudence dictates that investors prepare for bouts of financial market volatility from their efforts succeeding only in part."

Changing expectations for China's economic growth are another source of uncertainty likely to provide support for Treasurys, he said, noting remarks from the mainland's Finance Minister Lou Jiwei indicating that undershooting the 7.5 percent growth target could be acceptable.

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The safe-haven move may have started in September, with Treasurys eking out a positive return in the third-quarter, he noted.

The 10-year U.S. Treasury yield rose from 1.60 percent in mid-May of 2013, when the Fed first broached its plan to taper its asset purchases, to around 3.0 percent at the start of 2014. But despite expectations it would rise further, it has retraced, trading at around 2.3570 percent in early Asia trade Wednesday after touching more than one-year lows last week.

Others also expect long-term bond yields, which move inversely to prices, will remain depressed.

"This will continue to be the case as long as German Bund yields stay depressed," as the spread between 10-year U.S. Treasurys and German government bonds remains fairly wide, said DBS in a note last week. "Room for U.S. Treasury yields to head higher would be constrained if 10-year German Bund yields stagnate or fall further."

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DBS sees further declines in Bund yields as a distinct possibility, citing falling market rates and inflation expectations as optimism over the last round of easing from the European Central Bank (ECB) in September is fading.

DBS isn't alone in pointing the finger at Europe, when it comes to depressing bond yields.

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"The European recovery story is in shreds," David Goldman, managing director at Reorient, said in a note Wednesday. "Contagion from Europe is now the dominant economic story," he said, noting concerns Europe's economic deterioration -- as seen in data Tuesday showing German industrial production has fallen -- will affect growth everywhere else.

Despite widely held expectations the Fed's next move will be a rate hike, "the market continues to warn of disinflation, if not outright deflation. That opens the possibility for another notch down in Treasury yields," Goldman said.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1