Treasury Yield Curve Steepens to Record on Debt Demand Concern

Dec. 25 (Bloomberg) -- Treasuries fell, with the difference in yields between 2- and 10-year notes widening to a record amount, as investors bet the U.S. recovery will fuel inflation and reduce demand at the government’s debt auctions.

The 10-year note’s yield climbed to the highest level in four months as reports showed increases in sales of existing homes and orders for durable goods. The U.S. will sell a record- tying $118 billion of 2-, 5- and 7-year notes next week.

“We are in a steepening trend,” said John Spinello, chief technical strategist in New York at Jefferies Group Inc., one of the Federal Reserve’s 18 primary dealers, which are required to bid at government debt auctions. “It was the recognition that the Treasury will be extending the debt as we know it and the economy is showing signs of recovery.”

The benchmark 10-year note’s yield rose 26 basis points on the week, or 0.26 percentage point, to 3.80 percent, according to BGCantor Market Data. That’s the highest level since Aug. 10. The 3.375 percent security due in November 2019 fell 2 5/32 or $21.56 per $1,000 face amount to 96 16/32.

Two-year note yields rose 18 basis points on the week to 0.97, the highest level since Oct. 30. The note to be sold on Dec. 28 in a record-tying $44 billion offering traded at 1.02 percent in pre-auction trading. The debt drew a yield of 0.802 percent, the lowest ever, at the last auction, a $44 billion offering on Nov. 23.

‘Inflationary Pressures’

The difference, or spread, between 2- and 10-year note yields widened to 2.88 percentage points on Dec. 22. The previous record of 2.81 percentage points was set on June 5, when Treasuries plunged after a government report showed the smallest decline in U.S. payrolls in eight months. Ten-year note yields touched 4 percent the following week, the highest level in 2009.

“If you are going to have a recovery, you are going to have higher inflationary pressures, so the curve should continue to steepen from here,” said Dan Greenhaus, chief economic strategist at Miller Tabak & Co. in New York. “The curve could reach 300 to 325 basis points.”

Holders of U.S. Treasuries of all maturities have lost 3.3 percent this year, according to Bank of America Merrill Lynch indexes. That would be the worst performance since 1994.

American consumers’ spending and incomes climbed in November, indicating that the biggest part of the economy is poised to strengthen as the labor market recovers, government reports showed. Purchases rose 0.5 percent and incomes increased 0.4 percent.

Debt Sales

Existing home sales rose 7.4 percent last month to a 6.54 million annual rate, the highest since February 2007, from a revised 6.09 million pace the prior month, the National Association of Realtors said on Dec. 22. Sales were expected to rise to a 6.25 million annual rate, according to the median forecast in a Bloomberg News survey of economists.

Excluding demand for transportation equipment, bookings for long-lasting goods climbed a greater-than-forecast 2 percent in November, figures from the Commerce Department showed on Dec. 24 in Washington.

The U.S. will sell $44 billion in two-year notes on Dec. 28, $42 billion in five-year debt the next day and $32 billion in seven-year securities on Dec. 30. The five-year sale and seven-year offering equal the all-time highest issues of the securities set last month.

Seven-Year Auction

“The seven-year coming just a day before New Year’s eve, when the Fed had been a strong buyer of the seven-year sector to help out mortgage rates, that’s probably the auction to worry about,” Michael Pond, an interest-rate strategist in New York at primary dealer Barclays Plc, said on Dec. 24 in an interview on Bloomberg TV. “The two-year should be well spoken for. At year-end, there is plenty of demand for short paper. It’s really further out the curve that you have to worry about.”

President Barack Obama is borrowing unprecedented amounts for spending programs. U.S. marketable debt increased to a record $7.17 trillion in November from $5.80 trillion at the end of last year.

Treasury officials on Nov. 4 announced a long-term target of six to seven years for the average maturity of Treasury debt and said the department wants to cut back on its issuance of bills and two- and three-year notes.

Treasury yields will increase in 2010 as the Fed ends purchases of mortgage and agency securities, Barclays’s Pond said. The yield on the benchmark 10-year note may climb to 4.5 percent, he said.

The Fed said on Dec. 16 it will continue purchases of agency mortgage-backed securities totaling $1.25 trillion and about $175 billion of agency debt through the first quarter of next year. The Federal Open Market Committee and the Fed’s Board of Governors reiterated that “most of the Federal Reserve’s special liquidity facilities will expire on Feb. 1 2010.” The central bank completed a $300 billion program of Treasury purchases in October.