The run of bad news from the US subprime mortgage sector may have slowed down for now, but investors are watching government bond yields for any sign of the fear factor returning.

Gerald Lucas, senior investment advisor at Deutsche Bank, said: “Markets are going to stay nervous. There is a concern that the liquidity crisis in subprime will be a slow, drawn-out affair and delay any recovery in the housing market and the overall economy.”

The shape of the Treasury bond yield curve is one signal of investors’ worries. The relationship between maturities and yields shows how much investors are paid for investing funds for periods of up to 30 years.

Normally, investors should receive a higher return for tying up their money for longer. But that has not been the case in the US government bond market for some time. Since June, the two-year note yield has held above that of the 10-year note, a situation known as an inverted yield curve – except for a brief reversal in August.

Historically, whenever long-term yields have been below those on two-year notes, it has reflected a fear that the Federal Reserve has tightened policy too hard and that a recession could be looming.

This time some people have argued that a global savings glut and a hunt for higher returns, reflected and nurtured by slumbering equity and bond volatility, have kept long-term yields low – helping invert the yield curve.

Now, as subprime problems have surfaced, bouts of selling in equities have been accompanied by a steepening in the yield curve that has trimmed the inversion between two and 10-year yields. Safe haven buying in Treasuries generally pushes the two-year note higher (lowering the yield) before it affects longer-dated bonds, where value is governed more by inflation expectations. When the Dow Jones Industrial Average briefly fell below 12,000 last week, the two-year yield fell towards the 10-year yield.

While greater calm has returned to equity markets in recent days and pushed the two-year yield back above that of the 10-year maturity, some analysts believe a reversal of the inversion and a steeper yield curve beckons.

David Ader, bond strategist at RBS Greenwich Capital, said: “We are at the start of a steepening trend. A bigger premium for inflation risk and wider credit spreads is likely.”

While increased safe haven buying should result in a steeper curve, one catalyst for a pronounced move is the Federal Reserve’s reaction to any intensification of problems in the subprime market. For months, investors have swung from pricing in between one and three quarter-percentage point rate cuts over the ensuing year.

Given elevated inflation pressures, analysts say the Fed could decide to keep policy steady unless subprime woes start damaging the broader economy. That view could be prevailing when Fed policy makers conclude their two-day interest rate meeting on Thursday.

Mr Ader said the central bank’s policy statement could well “mention that subprime issues are on the Fed’s radar”. But the lack of evidence of any significant spillover meant “no pre-emptive urge” loomed in easing monetary policy.

While the Fed can wait, such a policy prescription may not last if the economy catches a severe chill from subprime.

Jim Caron, co-head of global interest rate strategy at Morgan Stanley, said: “If there is a problem, the Fed will cut rates fast and by a large margin.” Such a move, in conjunction with investors re-pricing risk and what he calls “stubbornly high” inflation, would steepen the yield curve, Mr Caron said.

A pronounced steepening of the curve could limit any decline in the 10-year yield, from which mortgage rates are set. When the 10-year yield falls, some homeowners can refinance mortgages at lower fixed rates. In the past, this type of activity has boosted consumer spending. But a steeper yield curve could limit the remedial influence of a refinancing wave, analysts say.

Any sign that subprime is hurting the broader economy will also push the bond market into action ahead of the Fed, said Mr Caron. “If the economy does slow as the subprime market problems spread, people will be very prepared to price in a lot of cuts.”

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