U.S. interest rates seen hinging on Fed's exit strategy

NEW YORK (Reuters) - U.S. interest rates in the second half will likely move on perceptions of how the Federal Reserve handles paring its burgeoning balance sheet and ending emergency funding programs, analysts said.

There have been growing concerns over the inflation fallout from the Fed's moves to bail out the economy after the credit crisis last autumn.

The Fed's unconventional funding programs, adoption of a near-zero rate policy and buying of Treasuries have helped to stabilize the economy, analysts say, but it is unclear how the bond market and economy will respond whenever the Fed moves away from the bailout programs.

An end to the Fed's emergency measures poses a "cliff-effect" risk for the bond market, according to Morgan Stanley.

The effect "increases the risk for a policy misstep and produces greater uncertainty," Morgan Stanley analysts wrote in their midyear outlook published on Wednesday.

They forecast benchmark 10-year Treasury note yields could push toward 4.25 percent by the end of the year, almost 0.70 percentage point above current levels. Short-term yields on the other hand will likely stay steady.

They also expect increased volatility and higher risk premiums on spread products like mortgage-backed securities.

In an effort to end the worst recession in decades, the Fed has doubled its balance sheet to $2 trillion in 10 months, while the U.S. Treasury is expected to issue $2 trillion in new debt this fiscal year.

The cost of the economic bailout has raised questions about the credit-worthiness of the United States, which in turn has caused a jump in long-term Treasury yields since March and a pounding of the dollar.

Inflation worries stemming from the burgeoning government debt load have pushed up long-term Treasury yields. Benchmark 10-year yields climbed more than 0.85 percentage point in the second quarter. The yield was 3.59 percent early Wednesday.

But the anxiety about the dismantling of Fed funding programs and its losing control of inflation is overstated, said Goldman Sachs.

"We see virtually no probability that this will be a problem in the months, quarters, and (most likely) years ahead," Goldman Sachs economist Ed McKelvey said in a note on Wednesday.

FED ASSURANCE

The Fed and other global central banks have pumped hundreds of billions into the financial system, which was pushed to the brink when Lehman Brothers collapsed.

In the case of the Fed, Morgan Stanley and Goldman Sachs estimate the Fed could reduce its balance sheet by $875 billion to $880 billion by ending various funding programs.

This amount of support will no longer be around beyond December, Morgan Stanley added.

On Tuesday, two Fed officials signaled the central bank would not rush to raise the key federal funds rate, which is near zero, or remove its accommodative policies, even as the economy emerges from recession..

San Francisco Fed President Janet Yellen told reporters on Tuesday, "It's not out of the realm of possibilities that the fed funds rate could stay at zero for the next couple of years."

St, Louis Fed President James Bullard acknowledged concerns about the Fed's unwinding of emergency backstops. "Without an exit strategy, expectations of high inflation may develop," he said at an event held at the Philadelphia Fed.

(Reporting by Richard Leong; Editing by Kenneth Barry)