June 7, 2007 / 7:46 PM / 10 years ago

Inflation worries stoke yield curve spread bets

NEW YORK (Reuters) - Bond investors' growing concern about global growth and inflation has battered long-dated U.S. Treasury prices and sent their yields higher than shorter maturities, triggering fresh market bets on the spread between the two.

The rapid flip-flop this week from a so-called inverted yield curve, where 2-year note yields traded above benchmark 10-year Treasury note yields, stunned investors, as the yields on longer maturies rose above yields on short maturities by the most in a year.

The spread between 2-year and 10-year notes widened on Thursday to 9 basis points, with the 10-year note yield at 5.12 percent US10YT=RR, above the 2-year note's 5.03 percent US2YT=RR, and the gap could widen further to around 20 basis points in the near term, analysts said.

Royal Bank of Canada Capital Markets said earlier on Thursday it had entered a new trade to sell 10-year notes and buy 2-years, expecting the yield gap to widen to 15 basis points, perhaps within a few days.

"The reasons for the trade include the notion that U.S. and global inflation are rising and that the Fed will lag other central banks (in raising U.S. interest rates) due to ongoing concerns about the housing sector correction," Marta said.

The increasing likelihood of more interest rate rises overseas, after the ECB raised rates on Wednesday and the New Zealand central bank surprised with a rise earlier on Thursday, is a main catalyst for the selloff in global sovereign debt that impacted U.S. Treasury prices.

The speed and timing of the Treasury market's moves "has taken people by surprise because it seems to be the data abroad that is driving it," said Matthew Moore, economic strategist with Banc of America Securities in New York.

By year end, the gap of 10-year Treasury yields over 2-year yields could steepen to between 20 and 25 basis points, Moore predicted.

Investors usually demand higher yields from longer maturities in order to compensate for the additional risk of holding securities over longer periods.

While analysts had been expecting the yield curve to return to normal, with longer-dated yields above short-dated yields, they thought it would happen because a slowing U.S. economy would force the Federal Reserve to cut short term rates.

Just a month ago, the prevailing market view was that by the end of 2007, the Federal Reserve would start cutting interest rates, which tends to pull short-maturity yields lower.

But a resurgence of global inflation worries has effectively extinguished investors' expectations for a Fed rate cut, and the Fed is now expected to hold interest rates steady through the end of this year.

"What is interesting is that this is a steepening sell off," said Josh Stiles, bond strategist with IDEAglobal in New York. "There is a growing concern about global demand and a more lasting global pick up in price pressures under way on a multi-year basis," he said.

Stiles expects the benchmark 10-year Treasury yield may have to rise to 5.25 or 5.30 percent before the market sell off abates.

However, this week's Treasury market sell-off, also driven by mortgage-related selling of U.S. government bonds and a rapid reversal of market positioning, may soon abate and perhaps partly reverse, some argue.

"You have to bear in mind that there is an irrationality going on in markets," said David Ader, head of government bond strategy with RBS Greenwich Capital in Greenwich, Connecticut. "This is a panic regurgitation of paper," Ader said.

However, he thinks the shift toward steepening of the yield curve could be sustained for a while. Ader expects the curve could steepen to between 17 and 21 basis points near term, levels it last reached in April of 2006.

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