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Analysis: Betting on further U.S. yield curve steepening? Not so fast!

FILE PHOTO: The United States Department of the Treasury is seen in Washington, D.C.

By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) - Investors betting that optimism over the U.S. economic outlook will lift yields on longer-term U.S. Treasury securities faster than short-term rates could be in for a major surprise.

A potentially chaotic U.S. presidential election next month and a resurgence in global coronavirus cases that throttles nascent economic growth could spur more safe-haven buying of Treasuries that could flatten the yield curve and upend the consensus view for continued steepening.

The Federal Reserve is also determined to keep interest rates low and is likely ready to intervene and scoop up Treasuries at any sign of a yield back-up that is not consistent with economic fundamentals, analysts said.

The yield curve, which refers to the usually upward sloping line that plots the interest rates of U.S. government debt across different maturities, has been steepening for several weeks amid expectations of additional government stimulus that could help the economy and require more borrowing by the Treasury.

The extra supply of U.S. debt could pressure Treasury prices and push up yields, which move in the opposite direction.

A steepening curve, when longer-dated yields rise faster than shorter-dated ones, typically signals higher inflation and brighter economic prospects.

Bond investors have started to price in a victory for Democratic challenger Joe Biden over President Donald Trump, an outcome which could mean billions of dollars of additional COVID-19 stimulus, aid for state and local governments, and infrastructure spending.

Big banks such as JP Morgan, Barclays, and BofA Securities have recommended curve steepeners, with hedge funds piling into the trade as well, analysts said, making it an already crowded bet.

The closely watched spread between two-year and 10-year yields <US2US10=TWEB> hit its widest since June 8 on Tuesday, up more than 30 basis points since late July. The five-year note/30-year bond spread <US5US30=TWEB> was also more than 30 basis points wider since July.

Two weeks ago, the U.S. 10-year note and 30-year bond yield gap <US10US30=TWEB> hit its widest since November 2016.

GRAPHIC: The 10/30-year spread is at its widest since November, 2016 - https://fingfx.thomsonreuters.com/gfx/mkt/nmovawanmva/Pasted%20image%201601931358623.png

GRAPHIC: The 10/2-year spread is at its widest since June - https://fingfx.thomsonreuters.com/gfx/mkt/dgkvlbymrvb/Pasted%20image%201601931177563.png

Rob Robis, chief global fixed income strategist at BCA Research, doesn't buy the curve steepening view just yet.

"The growth is shaky enough with so much uncertainty that the bond market is not comfortable re-pricing for higher yields and a steeper curve," he said.

Global coronavirus cases rose by more than 400,000 for the first time late Friday, a record one-day increase.

Jeff Snider, head of global research, at Alhambra Investments, said the 30 basis-point widening since July in both the five-year/30-year and the two-year/10-year yield spreads is not significant compared to historical bond moves.

"The movements are nothing more than market fluctuations," Snider said, adding that yields are trading within narrow ranges despite massive Fed action and indicate that economic risks are still tilted to the downside.

J.P. Morgan said in a research note that while it projects a steeper curve going into year-end, steepening positions are stretched, which poses a near-term risk.

GRAPHIC: The big short - https://fingfx.thomsonreuters.com/gfx/mkt/rlgpdjrjjpo/Pasted%20image%201602272720386.png

Kevin Muir, an independent prop trader in Toronto who broadly sees further curve steepening, thinks the market could see a 30-basis point correction "that comes out of the blue and shake some people out," in say, the yield spread between five-year notes and 30-year bonds.

Analysts also said a drawn-out and contested presidential election outcome could spur massive covering of shorts on the long end of the curve that could push yields lower.

DON'T FIGHT THE FED

Moreover, the Fed is committed to keeping short-term rates near zero for at least another three years.

Since March, the Fed has bought nearly $2 trillion in Treasuries, concentrating on short-dated to medium-term maturities.

"Investors and traders are likely to be cautious in shorting the market too hard or too far with the Fed in the wings," said Patrick Leary, chief market strategist at broker-dealer Incapital.

Low interest rates have spurred more U.S. companies to issue corporate debt, as demand for those bonds stayed robust despite the pandemic.

The last thing the Fed wants to do is to scupper a recovery with higher yields that undermine corporations trying to raise funds in the market, BCA's Robis said.

For now, Fed policymakers have no plan to change the nature of their asset purchases and go for longer-dated bonds.

But if rates were to rise too quickly, "it's safe to assume they would make this policy shift, especially if it caused a correction in the stock market," said Incapital's Leary.

(Reporting by Gertrude Chavez-Dreyfuss; Additional reporting by Saqib Iqbal Ahmed; Editing by Alden Bentley and Andrea Ricci)