From Bloomberg

March 1 (Bloomberg) — Past may be no prologue for Treasury investors when Federal Reserve policy makers begin to withdraw their unprecedented monetary stimulus without raising interest rates.

For the first time since at least 1980, a change in monetary policy may mean the difference between short- and long-term Treasury yields will widen rather than narrow. The threat of the Fed selling the $2.29 trillion in securities on its balance sheet, combined with record Treasury auctions, will keep longer-term yields higher, according to Deutsche Bank AG, one of 18 primary dealers that trade directly with the central bank.

A so-called steeper yield curve would boost borrowing costs for companies and home buyers while attracting money managers deterred by record-low rates. President Barack Obama needs to lure investors more than ever as Treasury extends average debt maturities and finances a budget deficit that the government predicts will expand to an unprecedented $1.6 trillion in the fiscal year ending Sept. 30.

“The policy for the Fed to keep rates low for an extended period of time will keep front-end rates lower for longer,” said James Caron, head of U.S. interest-rate strategy in New York at Morgan Stanley, another primary dealer. “The weight of supply and the risk premiums for inflation may rise as the Fed keeps rates low, that will increase the term premium on the curve and the 10-year note yield will rise to reflect that.”

Fed Funds Anchor

The yield curve, or the gap between 2- and 10-year Treasury note rates, widened to a record 2.94 percentage points on Feb. 18, before narrowing to 2.80 percentage points on Feb. 26. Yields on 2-year notes fell 10 basis points to 0.81 percent last week. Those on 10-year securities dropped 16 basis points to 3.61 percent even after the government sold a record $126 billion in notes and bonds.

Ten-year notes yielded 3.63 percent today as of 9:23 a.m. in Tokyo, and the curve spread was unchanged.

The Fed’s anchoring of its target rate for overnight loans between banks to a range of zero to 0.25 percent since December 2008 and record borrowing by the Treasury pushed the gap up from nothing in June 2007.

Deutsche Bank forecasts the curve will steepen to 3 percentage points as 10-year note yields climb to 4 percent by mid-year. Morgan Stanley expects 3.25 percentage points by the second quarter, with the 10-year note reaching 4.5 percent.

Investors would earn about $415,400 on a $10 million sale of 10-year notes combined with a $42 million purchase of two- year notes if the gap increased by 50 basis points, assuming two-year yield holds steady.

Discount Rate

The yield curve narrowed last week after the Fed raised the discount rate charged on direct loans to banks to 0.75 percent from 0.50 percent. The move increased investor focus on the next policy steps, after the central bank added more than $1 trillion to its balance sheet through emergency loans and securities purchases following the September 2008 bankruptcy of Lehman Brothers Holdings Inc.

Fed Chairman Ben S. Bernanke said last week that the change in the discount rate doesn’t mean the central bank is preparing to boost its target rate. In his semi-annual testimony to Congress, Bernanke reiterated that rates will remain low for “an extended period” because the economy’s “nascent” recovery isn’t strong enough to bear higher borrowing costs.

Excess Reserves

He also said Feb. 10 that he didn’t expect any asset sales in the “near term,” and that any sales would be at a “gradual pace.” Bernanke told Congress that the Fed “will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets.”

The economy expanded at a 5.9 percent annual rate in the fourth quarter, the fastest pace in six years, a report showed Feb. 26. Fed officials forecast the economy will grow 2.8 percent to 3.5 percent this year.

Still, the central bank is looking at ways of wrapping up the measures required to unlock credit markets. It expects to complete $1.43 trillion in purchases of mortgage-backed securities and housing agency debt this month and finished a $300 billion Treasury purchase program in October.

Four emergency lending facilities were closed last month. Policy makers are preparing to begin draining the more than $1.1 trillion in excess bank reserves they have pumped into the banking system by paying interest on deposits or using repurchases agreements with bond dealers.

Fed Holdings

The Fed’s assets now consist of about $777 billion of Treasuries, $166 billion of agency debt and more than $1 trillion of mortgages, central bank figures as of December show. When it starts selling, the supply of longer-term securities will increase. The average maturity of the Fed’s Treasury holdings is about seven years, according to Fed data.

Policy makers debated in January how to shrink the balance sheet, with some pushing to sell assets in the near future, minutes of the Jan. 26-27 Federal Open Market Committee meetings show. Bernanke and his colleagues agreed that the assets and banks’ excess cash will need to be reduced. They also said the central bank should dispose of mortgage and related securities purchased to support banks when credit market seized up.

‘Curve Steepening Pressure’

Fed officials “kept open the option of outright asset sales, suggesting that the curve steepening pressure would be maintained even as the Fed moves closer to an exit policy,” said Mustafa Chowdhury, head of interest-rates research in New York at Deutsche Bank, who correctly predicted in October that two-year notes would outperform 10-year securities even as policy makers began to consider how to pull back monetary stimulus measures.

A steeper curve provides more potential for profits at U.S. banks in so-called carry trades. JPMorgan Chase & Co., Bank of America and Citigroup Inc. boosted holdings in mostly fixed- income securities by an average of $35.5 billion in 2009’s second half, company filings show. Financial shares in the Standard & Poor’s 500 Index rose 81 percent in the last year.

The yield curve usually flattens when the central bank starts increasing funding costs. During the three months preceding or following the first interest-rate increase in Fed’s tightening cycles since 1980 the yield curve flattened, data compiled by Bloomberg show.

‘Unchartered Territory’

When the central bank last began lifting rates in June 2004, the spread narrowed from 1.9 percentage points to 1.51 percentage points by September. The gap was 2.27 percentage points in March 2004. In the decade before the credit markets seized up, 10-year Treasury yields averaged 0.81 percentage point more than two-year yields.

“We are really treading on unchartered territory through all of this,” said Christopher Sullivan, who oversees $1.6 billion as chief investment officer at United Nations Federal Credit Union in New York.

Sales by the Fed would come as the Treasury lengthens the average maturity of its debt to a range of six to seven years. The average due date dropped to a 26-year low of 49 months at the end of 2008 after the U.S. sold $1.9 trillion of short-term securities during the credit crisis.

Mortgage-Backed Securities

Lower 10-year yields would help keep a lid on mortgage rates as the central bank completes purchases mortgage-backed and housing agency securities. The difference between yields on Washington-based Fannie Mae’s current-coupon 30-year fixed-rate mortgage bonds and 10-year Treasuries was about 0.71 percentage point at the end of last week, just above its smallest since at least 1984, according to data compiled by Bloomberg. Yields on Fannie Mae and Freddie Mac mortgage securities guide U.S. home- loan rates.

Longer-term borrowing costs for the highest rated corporations have already increased. Investment-grade corporate bonds pay the highest yields relative to benchmark rates since September 2007 compared with shorter-maturing notes, according to Bank of America Corp.’s Merrill Lynch index data.

Investors demanded 1.92 percentage points in extra yield to own debt due in at least 10 years, compared with a 1.68 percentage point spread for notes due in three to five years, the data show. The 0.27 percentage point gap on Feb. 9 was the largest since Sept. 14, 2007.

Curve Outlook

As was the case during the last shift to tighter monetary policy in 2004, the curve will begin flattening when a Fed increase becomes imminent, said Adam Kurpiel, an interest rate derivatives strategist at Societe Generale SA in Paris.

‘The cyclical steepening phase for the yield curve has ended,” said Kurpiel. “The yield curve typically begins to flatten in a bear market, once the economy is doing well. We need a bear market for the flattening to really begin.”

Fed fund futures traded on the CME Group in Chicago on Feb. 26 gave a 32 percent chance the Fed will raise the benchmark lending rate by the end of September, down from 51 percent a week earlier.

“Reversing the balance sheet is an experiment in itself,” said George Goncalves, head of interest-rate strategy at primary dealer Nomura Holdings Inc. in New York. “People will start to anticipate that funding costs will go up a little bit, not tremendously.”