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By Michael Mackenzie

Published: May 27 2009 18:33 | Last updated: May 27 2009 18:33

These are testing times for dealers and investors in the US government bond market, as a rapidly rising budget deficit and the risk of higher inflation in coming years challenge the era of low long-term yields.

Unemployment may still be rising and the economy may still sport plenty of spare capacity, but long-term yields have been rising since the start of the year, with the trend accelerating in recent weeks.

That has overshadowed the buying efforts of the Federal Reserve, which has so far bought $130bn of government debt out of a planned $300bn purchase programme. The rise in Treasury yields is also pushing up mortgage rates, threatening any stabilisation in the housing market.

On Wednesday, the yield on the 10-year Treasury note reached a high of 3.58 per cent, a level not seen in six months. Although yields are low by historical standards, the 10-year note has risen from 2.1 per cent since December as investors have started absorbing an expected $2,000bn in new debt issuance for this financial year.

That bearish backdrop for yields has been compounded by nascent signs of the economy stabilising, which has sparked a big rally in equities and corporate bonds since March. All of which has attracted flows out of long-term Treasuries into higher yielding riskier assets.

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Harry Harrison, head of rates trading at Barclays Capital said: "There is a physical imbalance between Treasury supply and demand as economic fundamentals look better, there is more issuance of higher yielding corporate bonds and greater risk appetite, while the threat of deflation is lower."

Last week, the rise in yields accelerated when Standard & Poor’s revised the UK’s sovereign credit rating outlook to negative from stable. That triggered a slide in US equities, bond prices and the dollar. It is a very rare trading event for all three assets to fall together.

Treasury traders quickly concluded that S&P could soon express a similar view on the US, as the country rapidly escalates its official borrowing to make up for the loss of taxation revenue shredded by the recession. On Wednesday, Moody’s reaffirmed the US government’s triple-A rating in spite of a rising debt burden. While some investors are worried about the impact the fiscal outlook could have on Treasuries, others counter that the direction of yields will be mainly determined by how the US economy performs.

"Whether or not one of the major rating agencies decides to downgrade its outlook for the US in coming months is unlikely to make much of a difference to bonds," says John Higgins, analyst at Capital Economics. "More important will be developments in risk appetite and the real economy, recent improvements in which may not last."

A major player in all of this is the Fed, which through the buying of mortgages and Treasuries this year has sought to keep home loan rates low.

"Until you see signs from the Fed that they will up the Treasury buy-backs, the bond market will remain under pressure," said Rick Klingman, managing director at BNP Paribas. "The Fed will have to get involved as they need to see rates stay in a reasonable range until the economy is much stronger."

Indeed, Mr Harrison said Barclays does not rule out the Fed needing to buy more than $1,000bn in Treasuries to keep rates low.

An increase in Fed purchases of Treasuries, however, may increase the bond market’s vulnerability further down the road when the economy is on a sounder footing and the Fed starts to remove its support.

"There are concerns about the exit strategy for the Fed and the dollar," said Gerald Lucas, senior investment adviser at Deutsche Bank. "The big question for bond investors is about the size of the structural budget deficit after the economy emerges from recession."

While a combination of factors are hurting sentiment for long-term debt, demand for short-term paper remains high, with the Fed seen keeping rates low for an extended period of time.

This is resulting in a steeper yield curve, with the difference between two- and ten-year yields now above 2.6 percentage points and approaching the peak of 2.75 percentage points recorded in August 2003.

While a steep yield curve helps banks, who can borrow from the Fed at close to zero per cent and invest the funds in higher yielding securities, the rise in long-term yields is starting to weigh on mortgages. The rate for 30-year mortgage paper has jumped to 4.33 per cent from 3.86 per cent in the past month.

The steeper curve is normally associated with rising expectations of inflation and is a signal of a higher risk premium for Treasuries.

Not surprisingly, inflation expectations over the next 10 years have bounced from below 1 per cent, two months ago, to a recent peak of 1.84 per cent.

Crucially, when inflation expectations were last this high, back in September, crude oil was trading above $100 a barrel.

Worries over the rising tide of debt issuance by the US Treasury and prospect of inflation in the coming years is compounded by the fear that foreign investors, who hold more than half of the $6,000bn market, are starting to reassess the composition of their portfolios.

Copyright The Financial Times Limited 2009

Treasury sell-off

Published: May 27 2009 22:49 | Last updated: May 27 2009 22:49

So that is what happens when you try to take on the bond market. On Wednesday the US authorities must have been looking on in horror as long-term bond yields spiked. Markets were already wobbling last week. Now it looks like someone is hitting the panic button. Yields on 10-year Treasuries, for example, jumped more than 20 basis points in an hour and now stand at 3.7 per cent. Earlier this month, yields were 3.1 per cent.

The risk of rattling the bond market was always there. A government cannot go around dropping the odd trillion dollars and expect no one to notice. Equally, the ballooning of the Federal Reserve’s balance sheet has worried many, while the start of quantitative easing was an open invitation for investors to test the Fed’s hand. So far it is proving limp. This week, for example, the Treasury has issued another $100bn-worth of bonds. The Fed, meanwhile, has purchased less than a 10th of that.Treasury yields give cause for concern - May-27Eurozone’s outsiders outpace larger rivals - May-27Short view: Keep an eye on Treasuries - May-25Lex: Bond fears - May-26Long View: Bond risks - May-22

Of the three things spooking investors, one is real, while the others are overplayed. That yields on 30-year Fannie Mae mortgage bonds leapt about 45 basis points on Wednesday to 4.7 per cent is a genuine problem. If Americans cannot be coaxed into taking out mortgages or if refinancing cash vanishes from consumers’ pockets, forget about green shoots. Mortgage applications fell 14 per cent last week versus the week before, according to the Mortgage Bankers Association.

That the yield curve has steepened so dramatically highlights the two other fears, namely that the Fed may lose control of prices in future and that America’s bulletproof credit rating may be under threat. Here investors should heed Japan’s experience and relax a little. The downgrading of its sovereign debt in 2001 did not prevent authorities from keeping interest rates low nor did loose monetary policy and rising government debt lead to inflation.

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