Federal Reserve puzzled by yield curve steepening

WASHINGTON Sun May 31, 2009 3:48pm EDT

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WASHINGTON (Reuters) - The Federal Reserve is studying significant moves in the U.S. government bond market last week that could have big implications for the central bank's strategy to combat the country's recession.

But the Fed is not really sure what is driving the sharp rise in long-dated bond yields, and especially a widening gap between short and long term yields.

Do rising U.S. Treasury yields and a steepening yield curve suggest an economic recovery is more certain, meaning less need for safe haven government bonds and a healthy demand for credit? If so, there might be less need for the Fed to expand the money supply by buying more U.S. Treasuries.

Or does the steepening yield curve mean investors are worried about the deterioration in the U.S. fiscal outlook, or the potential for a collapse in the U.S. dollar as the Fed floods the world with newly minted currency as part of its quantitative easing program. This might be an argument to augment to step up asset purchases.

Another possibility is that China, the largest foreign holder of U.S. Treasury debt, has decided to refocus its portfolio by leaning more heavily on shorter-term maturities.

With officials still grappling to divine the factors steepening the yield curve, a speedy decision on whether to ramp up the Treasury debt purchase program or the related plan to snap up mortgage-related debt seems unlikely.

"I'm in wait-and-see mode," said one Fed official who spoke on the condition of anonymity. "We laid out the asset purchase plan and we're following it. That is going to have some affect on various interest rates, but together with a hundred other things. So I don't think we should be chasing a long-term interest rate," the official said.

BERNANKE

An important clue could come on when Fed Chairman Ben Bernanke testifies about the economy to U.S. lawmakers on Wednesday morning.

After lowering short term interest rates to near zero in 2008, the Federal Reserve said at its March meeting that it would buy up to $300 billion in longer-term Treasury securities over six months as part of its efforts to increase the money supply and ease the credit crunch of the past two years. So far, the Fed has bought $130.5 billion or about 44 percent of that $300 billion.

The Fed also has a goal of buying up to $1.25 trillion of mortgage backed securities (MBS) and $200 billion of debt issued by agencies like Fannie Mae and Freddie Mac. The Fed purchases of agency MBS total $507.075 billion so far in 2009.

But last week the benchmark 10-year U.S. Treasury bond yield jumped to a six month high around 3.75 pct, while the spread between 2-year and 10-year bond yields widened to a record 2.75 percentage points.

Economists at Barclays Capital in New York have argued that the Fed should announce plans to increase its planned purchases of longer-dated Treasuries to $1 trillion from $300 billion to drive yields back down, lower home mortgage rates again, and support the embryonic economic recovery.

They warn the Fed cannot afford to hold fire until its next scheduled policy meeting on June 23-24.

But the Fed is not so sure, and officials note that corporate bond spreads have narrowed over U.S. Treasuries, and that although mortgage rates have risen, they are still low.

An obvious culprit for the move in bond yields is the country's record fiscal deficit, which will generate a massive amount of new government issuance.

The U.S. Treasury must sell a record net $2 trillion in new debt in 2009 to fund a $1.8 trillion projected fiscal deficit, resulting from falling tax revenues, an economic stimulus package and sundry bank bailouts.

Investors began to worry this could erode the United States' cherished triple-A sovereign credit rating when Standard and Poors's on May 21 revised its outlook for Britain's triple-A status to negative from stable, blaming higher government debt.

The International Monetary Fund estimates that gross U.S. debt will reach 97.5 percent of the country's GDP in 2010, versus 72.7 percent of GDP for the United Kingdom.

But other Fed insiders said they have a problem blaming the steepening of the yield curve just on the extra supply of new Treasury debt.

While there has been a sharp deterioration in the U.S. fiscal outlook, this has been evident for months and the dramatic steepening of the curve only occurred this week.

Fed officials also believe that some better-than-expected economic data recently has encouraged investors to believe there is less need for the safe-haven of government bonds and more risk of inflation.

Dallas Federal Reserve Bank President Richard Fisher said on Thursday that the yield curve often steepens after a period of flatness heralding an economic recovery, but in this case is it likely a combination of factors.

"Obviously, there is a lot of supply of debt. Another way to interpret the steepening of the yield curve is ... confidence in the economy going forward," he told reporters in Washington after delivering a speech.

(Reporting by Alister Bull)

(Additional reporting by John Parry and Lynn Adler in New York, and Ros Krasny in Chicago; editing by Carol Bishopric)

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