By Chris Reese
NEW YORK, May 20 (Reuters) - In the eyes of the Federal Reserve, it's the best of both worlds in the bond market. That may not last.
Since March, long-term government bond yields have been rising while short-term yields have remained relatively low, helping banks boost profits by borrowing cheaply and lending at higher rates. At the same time, the rise in Treasury yields has not unduly affected long-term mortgage rates -- a big help for homebuyers in the U.S.
"As long as mortgage rates remain at their historical lows and the curve remains steep, it is good for both the Fed and the banks," said Rudy Narvas, senior analyst at 4Cast Ltd in New York. "Right now it seems to be a win/win situation for the Fed."
However, this idyllic situation may not persist, and that could pose knotty problems for the Fed.
If the economy continues to recover, long-term interest rates may continue to rise, and that may undermine the Fed's efforts to reduce borrowing costs through purchases of Treasuries. But intervening to reduce long-term rates hurts banks, which are benefiting from the ability to borrow cheaply at short rates and lend at higher longer-term rates.
"Absolutely it creates a dilemma," said Michael Wallace, global market strategist at Action Economics LLC in San Francisco. "You have these two forces going against each other."
YIELDS ON THE RISE
Longer-dated Treasury debt yields, which move opposite to prices, have been rising in recent weeks as investors turned to higher-risk investments such as stocks on expectations of economic improvement. Concerns about a wave of government debt issuance have also weighed on prices.
Shorter-dated Treasury yields have remained relatively anchored since December, however.
The yield curve, as measured by the difference between yields on two-year Treasury notes and 10-year Treasury notes, widened to about 239 basis points on Wednesday, the largest difference between the two since mid-November.
The steepening in the curve is of prime importance to banks as they try to restore their health after the financial crisis devastated the sector and contributed heavily to the economic decline.
Banks recorded historic losses in 2008, but many reported improved results in the first quarter due to their renewed ability to borrow money cheaply. When they borrow on a shorter-term basis and lend for longer terms at higher interest rates, it improves their profitability.
But the countervailing effect of the rising yield curve is that it has the potential to make mortgages less affordable.
THE FED'S CHOICE
So far, the Fed has been able to avoid this choice, as borrowing costs have not risen dramatically despite the recent rise in yields.
The Fed has been purchasing Treasuries to keep interest rates low, having bought about $115 billion of Treasuries since March as part of a program to buy $300 billion of government debt over a six-month period. Some believe the Fed will have to boost the size of this program if it wants to keep rates low.
"The fact that they continue to have this (Treasury) purchase program shows they have have a real concern about getting longer rates to low levels," said David Coard, head of fixed income sales and trading at The Williams Capital Group in New York.
The Fed also has been aggressively buying mortgage debt to help maintain low rates. Although the average 30-year mortgage rate climbed in the week ended May 14, it remained only slightly above the record low 4.78 percent reached twice in the past two months, according to Freddie Mac, the second-largest U.S. home funding company.
"On the mortgage side the ability to absorb higher U.S. Treasury yields might ultimately reach a natural limit," Dominic Wilson, economist at Goldman Sachs, said in a note to clients. He noted that overall borrowing costs are still less favorable than in 2007, and so "at some point a rising yield environment may become a greater policy concern."
Some analysts believe the Fed would side with lower mortgage rates rather than a steep yield curve.
"I don't think it is a crushing dilemma but it could get worrisome -- granted the curve is steeper but to keep the mortgage rate down would be beneficial to everybody," said Don Galante, senior vice president of fixed income at MF Global in New York. (Editing by Andrea Ricci)