US Treasurys Drift Upward But 'Cliff' Looms

U.S.Treasuries gained in price on Wednesday in light, post-Christmas trading, on chances of new volatility over fears about tax increases and spending cuts due to kick in as early as next week.

A package of automatic federal tax hikes and spending cuts worth $600 billion are set to go into effect in 2013 unless lawmakers in Washington are able to compromise to avert the fiscal crunch, which threatens to harm economic growth.

Concern over the impact of this so-called "fiscal cliff" may increase market volatility as we head into the weekend, potentially harming stocks and benefiting the U.S.dollar and safe haven assets including Treasuries.

"The rhetoric will start to heat up as we get closer to the weekend,'' said Bricklin Dwyer, an economist at BNP Paribas in New York. Markets may get more volatile heading into Monday's deadline if a deal looks increasingly unlikely.

"Those that are blindsided are going to be hit hard,'' said Dwyer.

The U.S.bond market was closed on Tuesday for Christmas and most major markets in Europe remained closed on Wednesday, which kept volumes low, at around 70 percent below their average, according to broker ICAP.

President Barack Obama is due back in Washington early Thursday for a final effort to negotiate a deal with Congress to avert or at least postpone the fiscal cliff. Traders have turned glum that even a temporary fix will be attained by Monday.

"The market seemed resigned that they might not get a grand bargain done before the end of the year. The best it can hope for is a 'kick the can down road' kind of deal so they could pick it up again early next year,'' said Larry Milstein, head of government and agency trading at R.W. Pressprich in New York.

The end of Bush era tax cuts and reductions in government spending are expected to dampen consumer spending and harm consumer confidence.

Rating agencies may also act on the U.S.' credit rating if negotiations drag on past the year-end deadline. Fitch Ratings and Moody's Investors Service currently rate the U.S. the top triple-A, while Standard & Poor's rank the country the second highest investment grade and all three agencies have negative outlooks on the country.

The failure of lawmakers to agree to a deal may harm confidence from "just the discomfort of realizing that Congress just won't do what's necessary when it's necessary,'' said BNP's Dwyer.

Benchmark ten-year notes were last up 5/32 in price to yield 1.76 percent, down from 1.78 percent on Monday. The yields have dropped from 1.85 percent a week ago.

Thirty-year bonds rose 8/32 in price to yield 2.93 percent, down from 2.94 percent on Monday.

The U.S.debt ceiling may again come into focus if negotiations drag through next year. BNP anticipates that the Treasury can stay under the ceiling until late February or early March through measures that include suspending investments in off-balance sheet vehicles, including a government employee pension fund known as the G-fund, and the exchange stabilization fund.

If no deal is reached by then, however, the country will again face the prospect of needing to raise the debt ceiling, or risk a catastrophic default on its debt.

Data on Wednesday also suggested U.S. Christmas shopping grew less than one percent from a year ago, which could be the worst year-end retail season since 2008.Economists blamed the disappointing sales on anxiety among Americans about their jobs and taxes next year if politicians fail to reach a timely budget compromise.

The Fed will buy bonds on Thursday and Friday as part of its 'Operation Twist' program,which involves buying long-term debt and funding the purchases with sales of short-term notes.

It will buy up to $5.25 billion in notes due 2018-2020 on Thursday and up to $5.25 billion in notes due 2021-2022 on Friday as part of Twist.

The Fed will replace this program with outright bond purchases ranging from five-years to-30 years next year.