Federal Reserve puzzled by yield curve steepening

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)