Federal Reserve puzzled by yield curve steepening

This article came out over the weekend. The gist is that the Federal Reserve has no idea why rates are rising in the long U.S. bond market (and they are basically scared sh@t.) Couple this with the Fed's leak last Friday to CNBC stating that the Fed is not targeting interest rates in the bond market and you have what appears to be a agitated Federal Reserve. Why would the Fed leak such a statement? My guess is they don't want to look like they have lost control of the U.S. bond market. If the market senses impotence by the Fed the sell off in bonds and the rising yields as a result will intensify.-Lou

Federal Reserve puzzled by yield curve steepening

By Alister Bull

WASHINGTON (Reuters) - The Federal Reserve is studying significant moves in the U.S. government bond market last week that could have big implications for the central bank's strategy to combat the country's recession.

But the Fed is not really sure what is driving the sharp rise in long-dated bond yields, and especially a widening gap between short and long term yields.

Do rising U.S. Treasury yields and a steepening yield curve suggest an economic recovery is more certain, meaning less need for safe haven government bonds and a healthy demand for credit? If so, there might be less need for the Fed to expand the money supply by buying more U.S. Treasuries.

Or does the steepening yield curve mean investors are worried about the deterioration in the U.S. fiscal outlook, or the potential for a collapse in the U.S. dollar as the Fed floods the world with newly minted currency as part of its quantitative easing program. This might be an argument to augment to step up asset purchases.

Another possibility is that China, the largest foreign holder of U.S. Treasury debt, has decided to refocus its portfolio by leaning more heavily on shorter-term maturities.

With officials still grappling to divine the factors steepening the yield curve, a speedy decision on whether to ramp up the Treasury debt purchase program or the related plan to snap up mortgage-related debt seems unlikely.

"I'm in wait-and-see mode," said one Fed official who spoke on the condition of anonymity. "We laid out the asset purchase plan and we're following it. That is going to have some affect on various interest rates, but together with a hundred other things. So I don't think we should be chasing a long-term interest rate," the official said.

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http://www.reuters.com/article/ousiv/idUSTRE54U1NZ20090531