Interest Rates Are Climbing, but May Not Last Long

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The sudden rise in interest rates to nine-month highs doesn't yet signal a turn, but that could change if Congress resolves the fiscal crisis hanging over the markets.

With stocks hitting multi-year highs and economic data surprising to the upside, investors have been selling Treasurys — which pushes up yields — and going into riskier assets.

But two things are keeping a lid on rates: worries about the automatic spending cuts — known as sequestration — if Congress doesn't resolve the budget impasse, and the Fed's continued purchases of Treasurys and mortgage bonds.

On Monday, the yield on the 10-year Treasury briefly rose above 2 percent for the first time since April, in part due to the stronger than expected report on durable goods orders.

"We've been more negative on the Treasury market ever since we cleared the debt ceiling debate," said John Briggs of RBS. "We felt it gave risk assets a green light to continue to advance and that money would be coming from safe haven instruments, notably Treasurys." Last week, Congress approved an increase in the debt ceiling to May, giving it time to hash out spending and the budget.

"The tail risks were substantially removed and part of what you're seeing here is an overdue sell off since the S&P 500 advanced to 1500," said Briggs. He said the sell off was actually a delayed reaction because the Fed was in the market, purchasing $30 billion in 10-year equivalents after the last Treasury auctions. "That was a technical factor that helped stem the sell off and it was overdue," he said. This week, the Treasury auctions $99 billion in two-, five- and seven-year notes.

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Briggs and others say the market focus should turn more bullish for bonds, when Congress addresses "sequestration" or automatic budget cuts that take effect March 1. While Congress wrangles, investors could rush once more to the safety of Treasurys.

But if Congress does deliver a reasonable plan to cut spending, it could be negative for bonds since it would eliminate some uncertainties for the economy. Economists say the automatic "sequester" cuts could be about a half percent haircut to GDP growth if allowed to occur.

The move up in yields also comes ahead of the Fed's two-day meeting, which starts Tuesday.

While little action is expected at the meeting, market chatter is rampant about what the Fed might do, especially after some traders perceived the Fed to be more hawkish when the minutes of its last meeting were released. "It seems the market might be disappointed," said Ian Lyngen, senior Treasury strategist at CRT Capital. "I think the consensus is they 're expecting the statement to be marginally closer to the FOMC minutes." Lyngen expects the move up to the two percent area to be temporary, and the market could be impacted by the Fed.

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Even so, the Fed is not expected to say much new, and market expectations for any new message are low. "It will be the minutes that will be more interesting," when they are released Feb. 20, said Briggs. The Fed is conducting $85 billion of asset purchases per month, in Treasurys and mortgage-backed securities and that is expected to continue.

"We think a sustained move through two percent would potentially cause further selling, but we think the move to the two percent area definitely brings us toward the cheaper end of the range," said Adam Brown, co head of Treasury trading at Barclays. "I think this is an area people were looking at as a relative support area for the market. I do think getting the two percent handle will bring in some cash. There's a lot of cash on the sidelines."

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It's probably holding off a little, considering the speed of the move. it's been a dramatic move, but we're still in the longer-term range, so I don't think any permanent damage was done," Brown said.

Briggs said he expects to see rates stay in a range of 1.7 to 2.1 percent in the near term, but then by the mid-year, the range could start to move toward 1.7 to 2.4 percent for the 10-year.

"Rates may not skyrocket higher because of the what the Fed is doing, but I think over time we're going to have a slowly increasing rate range," said Briggs. "You have this improving, continued-healing economy against the Fed purchasing of so much of the net supply.These things are going to be juxtaposed against each other."