TREASURYS YIELD TO ADVERSITY / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

HEARD ON THE STREET

AUGUST 18, 2010, 4:35 P.M. ET.

Treasurys Yield to Adversity

By RICHARD BARLEY

Shades of early 2009?

The extreme fear may have gone, but with 10-year Treasury yields heading back towards levels last seen as the global-financial system teetered on the brink, the same question has returned to center stage: Can U.S. policy makers stop the economy drifting towards deflation or will the sheer weight of deleveraging and weak demand be too strong to overcome?

Even as the Federal Reserve signals it is alert to the threat of deflation and is ready to act, bond yields have continued to slide. The 10-year yield, which hit 3.99% in April, is now at 2.61%. Just since Aug. 9, the day before the last Federal Market Open Committee meeting at which Fed officials decided to reinvest proceeds from maturing mortgage-backed security holdings into Treasurys, yields have dropped 0.22 percentage point.

That underlines the conundrum. The Fed's recent actions signal it is aware of the risks to the economy. It has made clear it intends to keep rates low for a long time, not just at the short end of the curve, but also further out. By announcing it will again buy Treasurys, albeit on a small scale, it has left the door open for bigger purchases. That could push yields yet lower in the short term.

But if, through such moves, the Fed actually succeeds in reflating the economy and rekindling inflation, buyers of 10-year Treasurys at 2.5% will take a serious hit.

In the depths of the credit crunch in early 2009, it was the wrong bet to buy Treasurys in the belief the government's response to the crisis would be overwhelmed by bank failures and an economic slump. In that year, Treasurys hit their low in January at 2.21%, but ended the year at 3.83%. Subsequently, beaten-down stocks went on the rampage.

This time it is less obvious that risky assets are ready for another big surge, even if the economy gently improves—credit spreads are much tighter and stock prices higher.

At the same time, Treasury yields look unlikely to go sustainably lower. Yes, another European crisis or a stock-market correction could drive more cash into the Treasury market short term. But investors may now be too fearful. Minneapolis Fed President Narayan Kocherlakota said Tuesday that markets over-reacted in interpreting the Fed action as signalling that the economic situation is worse than expected.

Prices certainly look stretched. Even though Japanese 10-year bond yields are now below 1%, after years below 2%, buying 10-year Treasurys at 2.61% leaves little room for error. U.S. inflation is subdued, yet core CPI is still positive at 0.9%. Even with high unemployment, there may be less slack in the economy than expected as job-seekers may not have the necessary skills for the jobs on offer.

While is it hard right now to see the catalyst for a sudden change of sentiment, investors should beware this is becoming a crowded trade. The Treasury rally may have run its course.

But, given the economic uncertainty, it is still tempting for those who fear the tail risk of deflation to park cash in Treasurys. The impact of such an outcome on risk assets would be terrible. Suffering a manageable loss on holdings of Treasurys if the recovery continues and yields rise may be preferable to suffering a large loss on stocks or other risky securities if the Fed fails.

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