Yield curve traces profile of market hunkering down for higher interest rates, inflation.

The steepening trend of the Treasury yield curve suggests that the market is bracing for stronger economic growth and the possibility of higher inflation in coming months, observers say.

"The shape of the yield curve is telling the market that long-term rates are headed higher." said Charles Lieberman, director of financial markets research at Chemical Securities. "The current steepening of the curve shows that the market is getting rid of expectations for an easing [of monetary policy] built into the market and slowly building in expectations for a tightening."

The yield curve begun to steepen last week when a higher-than-expected jump in the August consumer price index presented market participants with the hard reality that inflation is not dissapearing.

Since Sept. 13, the spread between the yield on the current 30-year bond and the yield on the two-year note has widened by 12 basis points to 226.

The Treasury yield curve is an important barometer of future market expectations. It has long provided investors in fixed-income securities with a way to track trends in interest rates.

The trend toward higher long-term rates has been accelerated by signs of strength in various sectors of the economy, including retail sales, housing, and initial jobless claims, market observers said.

Economists cite three main reasons for the trend toward a steeper yield curve: fears of higher inflation, a growing feral budget deficit, and uncertainty over President Bill Clinton's upcoming health-care reform program.

On the inflation front, Lieberman said last week's consumer price report sent a sobering blow to the market and brought the great bond market rally of 1993 to a grinding halt.

The rally was based on three basic premises: that the economy would remain weak in the second half of 1993, that inflation would continue to moderate, and that the Federal Reserve would either ease or hold steady on its interest rate policy.

Recent economic indicators have called all three of these assumptions into question, Lieberman said, and they indicate that the economy is not performing as poorly as the market thought. The 7.8% surge in housing starts for August bodes well for the economy and provides evidence that interest rate- sensitive sectors of the economy are showing signs of life, he said.

"The U.S. economy is healthier tahn the belief that is built into current interest rate levels," Lieberman said. "The steepening of the yield curve shows that the market is coming to grips with this fact."

Lingering fears over the budget deficit have also put upward pressure on long-term interest rates, economist said. They note that pressure on long-term rates is likely to continue through the end of the year as higher real rates are needed to finance a growing deficit.

"As long as the Treasury builds huge budget deficits, the market's potential will be limited," said Brian S. Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson Inc. The benefits of the Clinton administration deficit reduction package have yet to hit the market, he said.

Market economists cote the effect of health-care reform on the budget deficit as another element in the upward pressure that is being placed on long-term rates. Details of the administration's health-care initiative remain sketchy, but Treasury market observers agree that preliminary reports on the plan point toward the need for U.S. government bond issuance to support the plan, and thus a further widening of the federal deficit.

"Health care is not going to make the deficit smaller, but larger," said Robert Brusca, chief economist at Nikko Securities. "It looks like the plan will become a black hole for expenditures."

Thus far, say Brusca and other economists, the steepening of the Treasury yield curve has reflected investor concerns over the holding of long-dated paper in a gr-owing economy. Looking ahead, the economists agree that a further strengthening of the economy and speculation about a tightening of Federal Reserve monetary policy will add fuel to the trend.

"I expect the economy to finish the year strongly and that will push long-term rates higher and cause further steepening of the yield curve," said Chemical's Lieberman.

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