Feb. 19 (Bloomberg) -- Shifts in the relationship between U.S. government bonds with different maturities are semaphoring a warning that inflation may accelerate in the world's biggest economy even as growth deteriorates.

The two-year Treasury note yield has more than halved since Sept. 18, the day the Federal Reserve started cutting its key interest rate. The current yield of about 1.92 percent is far enough below the Fed's 3 percent rate to suggest investors expect additional moves from the U.S. central bank.

It's a different story at the other end of the yield curve. At about 4.6 percent, the 30-year bond yield is only 15 basis points lower than it was when the Fed downshifted into easing mode. As a result, the yield curve has steepened, driving the gap between the two- and 30-year securities to its widest level since July 2004 at about 268 basis points.

``Regardless of your view on the economy -- soft landing, hard landing or no landing at all -- investors should be concerned about the steepening of the yield curve,'' according to Tom Sowanick, who helps manage $10 billion as chief investment officer at Clearbrook Financial LLC in Princeton, New Jersey.

So-called breakeven rates, which measure the yield gaps between those Treasury bonds that pay returns tied to the inflation rate and those that don't, are starting to signal a change in the inflation outlook.

The gap between five- and 20-year breakevens has widened to 65 basis points, the most since at least August 2004 and more than double the 2007 average. While slower growth is likely to restrain consumer prices past the turn of this decade, Fed policy may be stoking the fires of future inflation.

More to Come

Prices in the futures market suggest there's about a 70 percent chance that the Fed will slash another half-point off its key rate when it next meets on March 18, dropping it to 2.5 percent. There's a 30 percent likelihood of a reduction of three- quarters of a point.

Adjusted for annual inflation, 30-year yields have collapsed as consumer prices have surged. The average real yield in the first 10 months of last year was 2.4 percent. In November, inflation jumped to 4.4 percent, matching the yield on the 30- year security to produce a real yield of zero for the first time in more than two years. The real yield is now about 0.5 percent.

``Risk managers have concluded that 30-year bond yields are too low in real terms, and also too low relative to intermediate note yields,'' Sowanick wrote in a Feb. 15 research report. ``Real interest rates will need to continue to rise in order for investors to be compensated for the risk that inflation may be working its way through the economy.''

Figures tomorrow are expected to show U.S. inflation accelerated to 4.2 percent last month from December's 4.1 percent rate, according to the average forecast of 29 economists surveyed by Bloomberg News.

One of those economists -- Avery Shenfeld, the senior economist at CIBC World Markets Inc. in Toronto -- is predicting a 4.4 percent inflation rate. At current values, that would slap the real yield on 30-year bonds back down to 0.2 percent.

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In times of crisis, governments are quick to revert to the interventionist templates that were the norm in decades gone by. With more financial-market landmines being triggered every day, the pace of interference is accelerating.

The U.K. government failed to find a buyer for Northern Rock Plc even after providing 55 billion pounds ($107 billion) of loans and guarantees to fill the mortgage lender's subprime- induced funding hole. Instead, it will nationalize the bank, in a humiliating capitulation that suggests letting the institution collapse when it first got into trouble might have been wiser.

Muni-Market Havoc

As the worsening creditworthiness of U.S. bond insurers wreaks havoc in the municipal securities market, New York Insurance Department Superintendent Eric Dinallo is proposing to carve the insurers in two, splitting subprime-infected debt from healthier muni bonds. Investors in the former are likely to turn to the courts to safeguard the value of their guarantees, according to analysts at Bank of America Corp.

In the broader economy, Fed Chairman Ben Bernanke is trying to thaw credit markets by wielding monetary policy to drive down borrowing costs, while Treasury Secretary Henry Paulson works his magic on the fiscal side with tax cuts. Paulson is also sponsoring efforts to persuade lenders to let people who fail to pay their mortgages hang on to their homes for longer.

So much for the free market. To misquote Richard Nixon's 1970s comment on British economist John Maynard Keynes, we're all Keynesians now.

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A mea culpa from analysts at UBS AG last week sheds unflattering light on the financial community's reliance on mathematical models. After Fitch Ratings published new rules for assessing the creditworthiness of collateralized debt obligations, UBS updated its models to test the likely outcome of the changes on credit ratings.

Among the findings, published in a Feb. 6 report, was a suggestion that AAA rated securities would get whacked under the new system. That turned out to be an error.

``We got a bit carried away by our eagerness to see the impact this new methodology would have,'' the UBS team, led by London-based strategist Etienne Varloot, wrote in a follow-up published a week later. ``We mixed up expected loss with percentage of default.''

So far, so esoteric. The interesting part is the caveat appended to the apology. ``This is a good reminder for all of us of how hard it is to look at new numbers or new models when one doesn't have experience about what the result should look like,'' the UBS analysts wrote.

So if you don't know the outcome in advance, it's tough to gauge how good your models are? That sounds illogical to me. No wonder banks are writing down billions of dollars in losses because their models didn't predict the potential damage from a collapse in the U.S. subprime mortgage market.

(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Mark Gilbert in London at magilbert@bloomberg.net

Last Updated: February 18, 2008 19:08 EST