U.S. Treasury yields, which fell on Tuesday, may stay low if U.S. government spending cuts slow economic growth and in turn force the Federal Reserve to hold interest rates low for longer than currently expected.
Government debt prices rallied on Tuesday as they shrugged off Monday's negative outlook revision by Standard & Poor's, as worries about the euro zone's debt problems showed Treasurys continue to hold relative safe haven appeal.
S&P's action is seen adding pressure to policymakers to agree on spending cuts by the 2012 election, which are needed to reduce the country's rapidly increasing budget deficit, or risk losing the country's top credit rating.
U.S. Treasury Secretary Timothy Geithner said on Tuesday that there was "no risk" the country would lose its top rating.
An agreement to cut spending, however, will also reduce funds that many see as having been vital to recent economic improvement. This in turn could harm the recovery and leave the Fed in a difficult situation.
The "U.S. government will be forced to put in place a fiscally contractionary policy that will sharply reduce the amount of stimulus that the public purse is pushing into both the domestic and global economy," said Credit Suisse consultant Sean Keane
"This will, if anything, require a more accommodative Federal Reserve policy setting, with monetary policy being forced to provide some balance to the fiscal withdrawal," he said.
The Fed's $600 billion quantitative easing program of buying bonds is scheduled to end in June, and the central bank has not yet made a statement over when it may plan to start selling $1.38 trillion in Treasurys it holds on its balance sheet.
Some investors including DoubleLine Capital's Jeffrey Gundlach see the economy at risk of giving back gains when QE ends, as occurred after the completion of the Fed's first quantitative easing program in March 2010.
"I think the U.S. economy is going to soften substantially if there is no further stimulus, or if there is an austerity program," he said on a conference call last week.
RISK FREE ASSETS
Treasurys have also retained a bid this week as investors struggle to identify what could replace the bonds as an alternative low risk investment.
"There are still a lot of issues, particularly in Europe," said Mirko Mikelic, senior portfolio manager at Fifth Third Asset Management in Grand Rapids, Michigan. "You have to look at your alternatives and weigh if you're not going to go into Treasurys what's the new risk free asset?"
Benchmark ten-year note yields fell two basis points to 3.36 percent, their lowest since March 24.
Gold prices also hit record highs for a second day in a row on Tuesday.
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