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Bank of America on Bonds, Budget Fight: A Look Ahead

By Matthew Craft

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%.

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.

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