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Yield curve predicting inflation, not growth surge

NEW YORK (Reuters) - A record wide gap between the yields of two-year and 10-year U.S. Treasury notes may have more to say about the threat of inflation down the road than the popular view that it’s a harbinger of dramatic recovery.

Market wisdom dictates that when the yield curve is steep, a rapid economic upswing is in store. Earlier this week, the spread between yields on two-year and 10-year notes reached a record-wide 287 basis points.

But many analysts believe the steep curve may mean something different this time -- though they’ve been wrong on such assumptions before.

This time, some say the steep curve presages a potential jump in inflation, as the Federal Reserve prints massive amounts of money to prop up the economy. Others point to the increasing supply of longer-dated Treasuries, as the government extends the life of its debt while investors, worried about a rate increase, crowd into shorter-dated notes and bills.

“If you look at the back end of the curve it’s predicting higher rates somewhere out at year four -- inflation would be a threat that far out. That is what the yield curve is predicting here, that this policy is opening the door to future inflation,” said Ronti Pal, head of U.S. dollar rates trading at Barclays Capital in New York.

INFLATION AHEAD

The Treasury is expected to issue as much as $2 trillion in government debt in 2010. The size of the planned issuance has stoked fears that the new money flooding the economy will depress the dollar and drive prices sharply higher.

Inflation erodes the value of Treasury debt over time. The recent dip in longer-dated Treasury prices and the spike in the yield curve reflects investors’ worries that real returns on their longer-dated U.S. bonds could fall.

The yield curve has in the past not been a strong predictor of inflation, but in those instances rates were notably higher than now and acted as more of a constraint on prices. The two-year note is currently yielding 0.92 percent. At the end of November, it hit a closing low of 0.66 percent, lower than at any time in the last 25 years.

“The vast majority of people think that the next phase of the interest rate cycle is going to be one where the market and the (Federal Reserve) more broadly is worried about inflation -- that means that the overall risk is that we’re going to have high inflation that leads to a steeper curve,” said Ian Lyngen, senior government bond strategist at CRT Capital Group in Stamford.

Since the Fed has emphasized that it will keep interest rates low for an “extended period of time,” investors generally feel comfortable buying shorter-dated notes. But the more distant future of interest rates isn’t clear. And the supply of longer-dated notes and bonds is set to grow faster than the supply of shorter-term securities.

Just as the current steepness of the yield curve suggests that the market expects inflation, the development of a weaker recovery with slower growth could cause the curve to flatten a bit.

“It is safe to say we will probably have growth that may warrant a positive yield curve, but maybe it doesn’t need to be as steep as it is because ... of the headwinds that the economy is facing,” said David Coard, head of fixed-income sales and trading at The Williams Capital Group in New York.

If economic indicators next year offer less robust readings, investors may return more eagerly to longer-dated Treasuries.

UNHEEDED WARNING

To be sure, investors may want to think twice before shrugging off the predictive powers of the yield curve. The curve “inverted” through much of 2006 and early 2007, with the yield on 10-year notes falling below two-year note yields. An inverted yield curve has often preceded recessions over the past 70 years, including the Great Depression.

The majority of economic analysts shrugged off the curve inversion, however, claiming the situation was atypical because a voracious appetite for long-dated bonds from overseas, especially China, was keeping long-dated yields unusually low.

However, the U.S. economy descended into one of the worst recessions in its history at the end of 2007 following the collapse of the U.S. subprime mortgage market and then the financial crisis.

“In hindsight, people should have paid more attention to it in 2006 and 2007,” said John Canally, investment strategist and economist with LPL Financial in Boston.

Still, Cannally suggests the yield curve’s predictive ability is in question, though he says it should portend at least a steady improvement in demand. “It tells you the current expansion is sustainable through 2010,” he said, adding “it may be less predictive, but not ‘un-predictive’ -- it bears watching closely.”

Additional reporting by Richard Leong and Emily Flitter; Editing by Leslie Adler

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