TREASURIES-Yields edge up as debt and recession worries collide

By Amanda Cooper

LONDON, April 26 (Reuters) - U.S. Treasury yields edged up on Wednesday, as traders assessed the combined impact of recession concerns, a potential standoff over the government's borrowing limit and renewed anxiety about the fragility of the banking sector.

Results from the earnings season so far show the financial sector's big guns mostly fared pretty well in the first quarter.

The same cannot be said of the mid-tier lenders. First Republic Bank reported a drop of $100 billion in customer deposits in the first three months of the year and said it was reviewing its options, including the creation of a "bad bank".

Adding to investor nervousness, macro data indicates the economy is showing signs of strain, after the fastest rate-hiking cycle in decades and still-hot inflation. The most recent read of consumer sentiment shows confidence hit a nine-month low this month.

This piles pressure on the Federal Reserve, which meets next week to set monetary policy. Money markets show traders believe the Federal Open Market Committee (FOMC) will raise benchmark interest rates by another 25 basis points, before cutting them later this year.

MUFG currency strategist Derek Halpenny said investors were already looking beyond the Fed's meeting and the event risk likely to dominate.

He cited "the debt ceiling fiasco and the impending moment of reaching the point of exhausting the extraordinary measures to keep the government functioning".

"In addition to this, we have uncertainties over the U.S. banking sector that won’t go away and the mixed economic data that mostly points to recession risks increasing," he said.

The 10-year Treasury note, which on Tuesday posted its largest one-day drop in a month, was last yielding 3.407%, mostly flat on the day, while the two-year note edged up 3 bps to 3.924%.

One market-based gauge of economic health, the difference between the yield on a three-month T-bill and the benchmark 10-year note, as at its most negative since the 1980s.

In the run-up to every U.S. recession, this spread has turned negative.

On Wednesday, the cost of insuring against a U.S. sovereign default shot to its highest since 2011 - when a previous debt-ceiling crisis led to the first U.S. ratings downgrade.

Data from S&P Global Market Intelligence shows credit default swaps - which pay the owner if the issuer of the underlying bond defaults - rose above 60 basis points on Wednesday.

This means it costs 60 cents to insure every $1 of Treasury debt, compared with an average of 16 cents over the last five years.

Stuart Cole, head macro economist at Equiti Capital, said the market is increasingly nervous about a possible standoff over the debt limit, the deadline for which is in June.

"The political deadlock between the White House and a Republican-controlled House of Representatives - and the political demands the latter is making before agreeing to the debt ceiling being increased - is starting to rattle the markets, given that so far neither side appears willing to even consider the possibility of compromising," he said.

The 3-month T-bill yield, which could be among the securities most affected by an impasse, has hit its highest in 22 years this month, according to Refinitiv data.

(Additional reporting by Bansari Mayur Kamdar in Bangalore; Editing by Barbara Lewis)