(Updates with background)
NEW YORK Oct 25 (Reuters) - The U.S. Treasury on Monday sold securities that fetched a negative yield for the first time, implying investors are willing to pay the government for the privilege of lending it money because they expect the inflation-adjusted notes to pay more later.
The $10 billion debt sale reflected the widely held view that the Federal Reserve will next week announce plans to buy more Treasuries to jump-start a sluggish economy.
The sale comes amid Federal Reserve efforts to spur inflation. Some policymakers are concerned the low level of inflation leaves the economy at risk of a deflation that could further sap an already weak recovery.
Investors also expect if the Fed prints more money to buy assets -- a decision likely at the next meeting of policymakers -- it will spur inflation down the road. Since TIPS yields adjust for inflation, the investment could ultimately pay off.
Typically, investors buy a new Treasury bond at "par" or $100. At Monday's auction of five-year Treasury Inflation-Protected Securities (TIPS), they paid more than $105 and accepted a security that yields nothing even after factoring in a 0.50 percent semiannual interest payment. For more see [ID:nTAR000400].
"This shows negative yields are not a turn-off to investors," said Michael Pond, co-head of U.S. rates strategy with Barclays Capital in New York.
The Treasury has been borrowing cheaply since the Fed brought short-term rates down near zero since December 2008. It even sold bills at zero percent during episodes of safe-haven stampedes during the global credit crisis.
While a negative yield clearly benefits the federal government by lowering its borrowing cost, investors bought the five-year TIPS on expectations that the Fed will proceed with a second round of asset buying, or quantitative easing that has been dubbed 'QE2'.
If QE2 raises inflation to 2 percent, a level which Fed Chairman Ben Bernanke recently cited, investors will profit from a widening in the yield gaps between TIPS and regular Treasuries. This could even happen if the real yields on TIPS remain negative.
The five-year TIPS "breakevens" were last quoted at 1.68 percent on Monday, compared with 1.25 percent in late August.
In the open market, five-year and other short-dated TIPS turned negative in late September on bets that increased bond purchases from the Fed will push down real interest rates, or borrowing costs excluding inflation.
Fed policymakers have expressed worries over the threat of deflation where a crippling cycle of falling prices and real interest rates could inflict long-term damage to an economy.
If the Fed engages in further quantitative easing in the form of buying more bonds, the U.S. central bank hopes to wipe out deflation risk and inflate higher asset prices. Rising asset values could in theory encourage investments and spending and in turn bolster economic activity to more desirable levels. (Editing by James Dalgleish, Chris Sanders, Burton Frierson and Kenneth Barry)
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