As Risk Appetite Returns, What Next for Treasurys?

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In markets unused to major surprises, the news that several members of the Federal Reserve's governing body wanted to halt its quantitative easing program earlier than expected caused a kerfuffle on Thursday.

The prospect of yields on U.S. Treasurys rising above 2 percent for the first time since April last year has emerged after they shot up following Thursday's news, and the announcement that the U.S.'s rulers had sealed a deal on the feared "fiscal cliff" earlier in the week.

Treasurys are a victim of their own success as a safe haven.

Yields have been kept low in recent months by the Fed's mass bond-buying program, and by their safe-haven status as a series of crises threatened elsewhere.

Yet now an increasing number of analysts are cautioning that they are set to rise again as markets turn to riskier assets.

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Fears that the U.S.'s credit rating may be threatened by politicians' failure to agree on the spending cuts needed, which many have warned could just postpone the crisis, are also a potential negative for bonds. There are even worries about the potential for default, as no agreement has been reached on whether or not to increase the debt ceiling — although most believe this is only a remote possibility.

Brett Rose, interest rate strategist at Citi, changed his rating to "sell" from "buy" on 10-year Treasurys earlier this week, after issuing a "buy" recommendation in late November. He argued that the fiscal cliff deal took away "the majority of the risk" he had feared when issuing his call.

A comparatively strong situation for U.S. corporates could also send yields higher.

Credit analysts at RBS pointed out that the US is entering a "re-leveraging period." They added: "With record-low yields, growing balance sheets and shareholder-friendly activity,there is less upside left for bondholders."

A "noisy upward glide" for Treasurys in the medium term was forecast by interest rates strategists at Lloyds — although they cautioned that the medium-term rally in riskier assets does not necessarily mean that investors should "embrace the risk-on theme for the longer haul."

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John Higgins at Capital Economics also believes that the current weakness in Treasurys won't last and forecast the yield on 10-year Treasurys will drop back to around 1.5 percent soon and stay around there for most of 2013.

"Appetite for risk could wane again if the Democrats and Republicans remain at loggerheads over public expenditure, or if events further afield take a turn for the worse — say if the crisis in the euro-zone flares up," he argued.