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Could a budget fight rattle the bond market?

Published on NewsOK Modified: December 16, 2012 at 11:26 am •  Published: December 16, 2012

It's a widely shared view across Wall Street. As they lay out predictions for next year, bankers and money managers paint a mostly sunny picture.

Hiring and the housing market keep getting better, consumer confidence is up, and many predict the stock market will hit an all-time high in 2013. For the first time in years, it's hard to find anyone fretting about Greece. All those signs point to higher long-term rates.

But the next few months could get rough.

"We'd all be talking about our solid economic growth next year if we weren't talking about the fiscal cliff," says Tom Porcelli, chief U.S. economist at the Royal Bank of Canada.

Porcelli says a final budget agreement is sure to weigh on the economy, mainly because he expects the two sides to let a 2-year-old cut in the Social Security payroll tax expire. If that happens, it would be like an immediate pay cut for every worker in the country.

"The big economic damage comes from the payroll tax cut going away," Porcelli says. "It doesn't matter how much you make, if you take home a paycheck, you'll get hit by that."

If Americans spend less as a result, it's sure to turn up in the steady march of sales reports and surveys that traders monitor. That could push the 10-year Treasury yield back below 1.5 percent in the first few months of next year, Porcelli says. But the yield probably wouldn't fall as far as it did in July.

"People thought the world was cracking back then," Porcelli says. He can dream up a scenario in which panic sets in — a war in the Middle East and a deep slump in China — and traders rush into the Treasury market, but it takes a vivid imagination.

The big worry earlier this year, Misra says, was that a missed debt payment by Greece could lead to bank failures in Europe and spread to the U.S. The European Central Bank eased those fears of "contagion" when it pledged to stand behind those countries' government bonds. Problem solved — "at least for now," she says.

So after the budget battle in Washington ends, and if Europe remains calm, things should look better. By the middle of next year, business spending, the housing market and eventually more jobs should give the economy and stocks — and bond yields — a lift.

Harris, the Bank of America economist, sees the economy chugging along at a 2.5 percent clip in late 2013. The bank predicts the 10-year Treasury rate will creep back above 2 percent, as big investors start shifting money out of their favorite hiding spot.

The bank says this "great rotation" from bonds to stocks should help drive the Standard & Poor's 500 index past its all-time high of 1,565 to 1,600 next year. The index closed Friday at 1,414.

"There's a better story out there," Harris says, "if we can just get Washington out of the picture."