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Debt drama fails to hit markets’ panic button

Market Beat

Where is a good old-fashioned market crash when you really need one?

Wall Street could have ended this pathetic debt-ceiling drama in a hurry this week, if only investors had been willing to vote with their dollars.

Bail out of stocks, drive Treasury bond interest rates to the moon and push gold up to $2,000 an ounce. That would have sent the pols a message to get their act together.

Instead, we got a slow-motion stock sell-off that clearly didn’t make the point with Congress.

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And instead of fleeing Treasury bonds as Washington barrels toward potential default, the world was piling back into U.S. long-term debt by the end of the week, pushing rates down.

How’s this for showing Congress who’s boss: The 10-year Treasury note yield, a benchmark for many other interest rates, ended Friday at 2.80%, down from 2.95% on Thursday and the lowest since November.

Yeah, that’ll strike fear in the hallways of Capitol Hill.

If Congress doesn’t agree to raise the $14.3-trillion debt ceiling by Tuesday the Treasury will begin to run dry. At some point, some of America’s creditors and beneficiaries (such as Social Security recipients) won’t get paid.

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Trying to make sense of markets’ moves has been more frustrating than usual because of the political impasse over the debt ceiling.

Heading into the weekend with nothing resolved, here’s a scorecard of what has happened in global markets leading up to this point, and some handicapping of what may be ahead:

Money markets: Maybe the biggest irony of the debt debacle is that some investors have become wary of the securities normally considered the safest of all — short-term Treasury bills.

The market yield on three-month T-bills has jumped threefold in the last week, to 0.094% on Friday from 0.033%. Granted, the rate still is a pittance, but the sharp move up shows the markets’ underlying nervousness about short-term government debt.

If the Treasury is going to default, the first victims might be owners of debt maturing very soon.

What’s more, some investors have been pulling cash out of money market mutual funds in recent weeks, amid concerns about short-term debt in Europe and, more recently, on fears of upheaval in the Treasury bill market. The funds’ sales of T-bills to meet redemption requests also have put upward pressure on yields, said Justin Lederer, an interest-rate strategist at bond dealer Cantor Fitzgerald in New York.

If investors want absolutely safety for their cash, they’re probably doing one of two things: taking it to the bank, where it’s covered by federal deposit insurance; or stuffing it in a mattress. (Of course, just how safe your mattress would be is debatable. What if the house burns down?)

Bonds: The nightmare scenario for bond investors was supposed to go like this: The risk of default on government bonds, or of a downgrade of the nation’s credit rating, would stoke selling of Treasuries that would send market yields soaring. That, in turn, would push up yields on corporate, municipal and other bonds. Everybody loses.

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But it hasn’t happened that way. Yields tumbled on longer-term Treasuries this week. The rate on 30-year T-bonds, in theory the riskiest of Treasuries, ended the week at 4.12%, down from 4.26% a week earlier and 4.39% four weeks ago.

Whatever fear global investors may have about a potential U.S. debt default or a ratings downgrade, it’s being trumped for the moment by another fear: that the economy could be headed back into recession.

That was the warning in the government’s report Friday that the economy grew at a dismally weak annualized rate of 1.3% last quarter. “If we’re not in a double dip we’re approaching one,” said Ray Remy, head of fixed-income at Daiwa Securities in New York.

Many economists disagree, and still are clinging to expectations of faster growth in the second half of 2011. But Friday’s report didn’t help that case.

With the economy faltering and Washington politics at their worst, many investors again are looking for a haven. Treasuries still are fitting that bill, though it may well seem counterintuitive.

More surprising, perhaps, is that corporate and municipal bonds also have continued to attract buyers. If investors really begin to worry about recession they’re likely to begin selling lower-quality corporate and muni issues, pushing those yields up. So far, though, bonds in general are the bright spot in many investors’ portfolios this year.

The dollar: The U.S. currency has slumped in recent weeks, suffering collateral damage from foreigners’ worries about a debt default and about America’s image in general.

The buck has fallen sharply this summer against the Swiss franc, the Japanese yen and the Brazilian real, among others. Still, if there’s a panic out of the dollar, it’s happening in slow motion.

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And against its main rival — the euro — the dollar is no weaker than it was in April. The euro ended Friday at $1.439, up slightly from $1.436 a week ago.

The U.S. government’s official stance is that it favors a strong dollar. But everyone knows that’s just a line. The dollar’s latest slide will provide more help to American exporters by making their products less expensive overseas.

And for U.S. investors in foreign stocks or bonds, a weaker dollar means foreign-market losses are muted, or gains are enhanced. That’s one reason foreign stock mutual funds have held up as well as they have this year.

The average European blue-chip stock is down 4.3% year to date measured in euros, but up 3.1% in dollars.

U.S. stocks: Congress did manage to get under the equity market’s skin this week. Most major share indexes fell between 4% and 5%, their worst one-week losses since summer 2010.

The Dow Jones industrial average slid 4.2% for the week, including Friday’s drop of 96.87 points, or 0.8%, to 12,143.24.

But if investors believed that the debt drama in Washington spelled absolute ruin for the economy, the market presumably would be down drastically. Even with this week’s losses, key indexes are above their June lows and not far from their spring highs. The Dow is off 5.2% from its multiyear high of 12,810 reached April 29.

Why haven’t investors been more spooked? One reason is that many believe that Congress will reach an eleventh-hour deal on the debt ceiling.

Another reason is that second-quarter earnings reports from many major companies have been robust. Even in a slow-growing domestic economy, plenty of companies have been able to post strong results.

Case in point: Online travel services firm Expedia Inc. late Thursday said second-quarter profit surged 25% on a 23% gain in revenue. The stock soared $2.70 to $31.69 on Friday, its highest level since 2007.

Buyers of Expedia shares must believe that, debt drama or no, the world will go on and people still will travel.

“Anyone selling stocks today has to be assuming that earnings will decline from here,” said Jack Ablin, chief investment officer at Harris Private Bank in Chicago. That’s not a bet that he’s willing to make, he said.

But a crucial question is whether investors have thought through the implications if Congress and the White House were to reach an agreement to significantly slash federal spending. That $1-trillion-plus annual government deficit provides a lot of purchasing power in the economy, either directly or via payments the U.S. makes to the jobless, retirees and others.

“It’s a simple fact — we’ve got austerity ahead,” Ablin said.

Once the debt crisis is resolved, one way or another, investors will turn their focus back to the economy. The rush into Treasury bonds says the economy won’t get better soon; the stock market still is buying the second-half-rebound story.

Somebody must be wrong.

tom.petruno@latimes.com


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