Longer-dated U.S. Treasuries edged higher in European trading on Friday, supported after Moody's put Spain's sovereign rating on review for a possible downgrade. With most market participants appearing to believe that U.S. lawmakers will reach a deal to lift the government's borrowing limit to avert a default, the rating agency's move on Spain refocused attention on the euro zone's rumbling debt crisis.
Benchmark 10-year T-notes rose 5/32 in price to yield 2.94 percent, down 1.6 basis points from late U.S. trade on Thursday. The yield fell to a session low of 2.962 percent in Asian trading after the announcement from Moody's.
Ten-year T-note futures were last up 3/32 at 124-19/32 after S&P futures fell 0.6 percent on news that the U.S. House of Representatives put off a vote on a Republican budget plan that had been expected on Thursday.
U.S. lawmakers must lift the government's $14.3 trillion borrowing limit by August 2 or risk a devastating default.
Bond traders see lack of progress on the U.S. debt talks weighing on riskier assets and favoring Treasuries, but uncertainty on how the tug-of-war in Washington will play out has lifted the cost of insuring U.S. debt against default to two-year highs, according to CDS provider Markit.
"The longer these debt talks linger the more pressure equities will be under," a trader said.
"We could be in a position where in the event of a downgrade, Treasuries would initially sell off but equities would be hit hard and you could have the usual flip-flop right back into Treasuries," he said.
Market players expect the U.S. government to avert a default, but also think that a downgrade of the U.S. sovereign rating is probably unavoidable, said Shinichiro Kadota, non-yen fixed income strategist for Barclays Capital in Tokyo.
Regardless of whether U.S. lawmakers decide to adopt a Republican plan or a Democratic proposal or come up with a compromise deal to trim fiscal spending, they seem unlikely to agree on cuts big enough to satisfy ratings agencies such as Standard & Poor's, some strategists say.
Cutting the U.S. deficit by some $4 trillion over 10 years would be a good start, but more savings would be needed over time to bring the country's finances under control, ratings agency Standard & Poor's said on Thursday.
"There could be some intraday moves after any rating action, but there probably won't be a full-blown sell-off," Kadota said.
He added that Barclays Capital's forecast is for the 10-year yield to stand at 2.9 percent at the end of September, pretty much steady from current levels.
Treasuries slightly underperformed German government bonds, with the 10-year T-note yield premium over Bunds rising to 34 bps on the day from around 31 bps at the European close on Thursday.
"We're probably headed toward not having a medium- to long-term fix, ending up with a short-term lift of the debt ceiling," said Lloyds Bank strategist Eric Wand.
"That should keep Treasuries as the poor relation versus other triple-A products."
Erik Ristuben, chief investment officer for client investment strategies with Russell Investments, said in a conference call that a U.S. downgrade would "bring an emotional response" in equity markets and the 10-year Treasury yield could rise as much as 50 basis points but then come back down over time.
