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Could a budget fight rattle the bond market?

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NEW YORK (AP) — On the road and in financial markets, it pays to ask somebody with a good sense of direction.

Two years ago, most of Wall Street's economists believed interest rates had bottomed out. But not Priya Misra, a top investment strategist at Bank of America Merrill Lynch.

She was one of few to argue that the sputtering U.S. economy and the European debt crisis would knock long-term interest rates to record lows in 2011.

"I was called quite crazy at that point," she says.

Her forecast looks clear-sighted today: The rate on the 10-year Treasury note, an all-important anchor for mortgage rates and other loans, seems stuck under a historically low 2 percent.

So what does Misra think now?

Long-term interest rates will creep higher, she says, as the economy gradually gains strength. The wild card is Washington, where talks are under way to avert tax increases and government spending cuts scheduled to start in January.

Most on Wall Street are confident that congressional Republicans and the White House will stave off the full "fiscal cliff" because the stakes are so high. Economists say the tax hikes and spending cuts could trigger a recession early next year.

"Our assumption is that a deal will get done," Misra says. If the two sides fail to strike a bargain, "politicians know that the markets will take it very badly and blame Washington for it."

Confidence in a deal may be shaken, pushing Treasury yields lower, if the talks drag on too long. Ethan Harris, Bank of America's chief U.S. economist, says it looks increasingly likely that budget negotiations will run into the new year.

If that happens, it may take the financial markets to force Congress to compromise.

"Congress and the president have given themselves way too much to do in way too little time," Harris says. "Something has to slap Washington in the face, and it'll be the stock market."

Why not the bond market? A fight over a government's budgets and debt might be expected to send investors fleeing from its bonds, causing prices to fall and yields, which reflect the government's borrowing rate, to climb.

Battles over budgets in Spain and Italy, for instance, regularly cause those countries' borrowing rates to jump. In the United States, traders say a brawl in Washington would have the opposite effect.

That's because rates are also a barometer of worry. When the world economy appears in danger, banks and big investors hide money in Treasurys, ignoring mounting U.S. government debt because they see this country, the world's largest economy, as a trustworthy borrower.

In July, fear that Europe's debt troubles could set off a global financial crisis drove the 10-year Treasury rate to a record low, 1.38 percent. Since then, the European Central Bank has taken steps to calm the crisis, and the 10-year Treasury rate has climbed. It was 1.70 percent on Friday.

Today, the economy is healthier than it was two years ago, when Misra made her prescient prediction about record-low interest rates.

But a hard enough blow could still send it into a recession. The biggest difference now is that Misra and the rest of the Bank of America strategists think the biggest threat comes from Washington, not Europe.

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."

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