The Treasury market has suddenly moved into uncharted waters, with yields touching all-time record lows across the maturity spectrum.  Although yields backed up slightly by week's end, 10-year note yields on Wednesday dipped momentarily below 4% -- a four-decade low -- and 5-year yields briefly approached 3% -- eclipsing the record low set at its first issue in 1963 by 50 basis points.  How low can they go?  It's a tough call: Intuition says that Treasuries are expensive, but intuition has failed miserably this year, and it is hard to know in the current volatile market setting what scenario is in the price.  After all, if yields stand at these bargain-basement levels today, where would they be in a double-dip deflationary scenario?  A host of analytical crosscurrents hints that the potential for further downside is limited, unless Steve Roach's deflation fears are realized (see "A Deflationary Mosaic," Global Economic Forum, August 15, 2002).  And I believe technical factors, especially mortgage hedging, could push yields down even further.  Our suspicion is that growth is the key driver: If we could call the bottom for stock prices, we could probably call the bottom in Treasury yields.

That hunch is based on our parsing of the factors recently driving the slide in yields.  Declining inflation expectations likely pushed yields lower from May to June.  But the very recent plunge in yields over the past month appears also to reflect the sea change in prospects for US economic growth.  That's because most of the recent decline appears to be in real yields rather than in inflation premiums.  We judge that approximately by looking to the Treasury's Inflation Protected Securities, or TIPS, the closest thing we have to a real yield.  The yield on the 3% 10-year TIP that was auctioned a month ago has fallen sharply, by 50 basis points, or roughly the same decline as that in comparable 10-year notes.

We are well aware that drawing inferences from the relatively illiquid TIPs market is fraught.  Our Treasury expert Bernd Wuebben believes that the sudden interest in TIPs -- and thus their outperformance over the past month -- reflects micro factors such as investors' need to diversify risk more than it reflects macro issues. The rally in TIPs also reflects new interest in them as some managers have launched so-called "real return" funds.  Still, I believe there's no mistaking the fact that a weaker economy has driven the rally.  While there's a lot of economic weakness already factored in to the price, I believe still-weaker growth could push yields slightly lower, and conversely, signs of reacceleration will likely push them significantly higher.

This appraisal appears to fly in the face of the factors shaping the yield curve recently.  After all, the conventional Treasury yield curve has flattened by about 8 basis points over the past month as the decline in 10-year yields outstripped that in 2-year rates, suggesting declining inflation expectations.  But several other important factors have helped to flatten the yield curve lately.

Indeed, I see growing risk aversion as a second factor that has been driving both nominal and real yields lower.  The negative correlation between stock and bond prices that surfaced a year ago is ample testimony to that shift; the rising equity-risk premium that our Quantitative Strategy team extracts from a dividend-discount model tells the same story.  Typically, stock and bond prices are positively correlated, as weaker growth undermines earnings expectations and thus depresses both stock prices and interest rates.  I believe the current negative correlation, in contrast, reflects investors' myopic focus on near-term earnings, so that falling stock prices drive down yields (see Steve Galbraith's,  "Too Much Worship at the Temple of Visibility," Investment Perspectives, May 15, 2002).  That negative correlation appears to have made investors distrust dividend-discount and stock-bond models -- they haven't worked lately.  But if asset allocators finally screw up their courage enough to begin to move out of bonds and into stocks, I believe yields will rise.  That process may have begun this week as CFOs certified their financial statements.

Deflation fears appear to have played a tertiary role in the recent yield decline, but could figure more prominently in the future if there is a deflation scare.  The Treasury market now seems to be discounting 1.6% inflation, judging imperfectly by the spread between the current 10-year TIP and comparable conventional off-the-run Treasuries.  That spread is well above the 60 basis points hit in the aftermath of the Long Term Capital crisis in 1998, so a true deflation scare could bring nominal yields down significantly.  In our view, "core" inflation is bottoming near 2%, and reflationary policies are likely to put a floor under inflation expectations.  But further disinflation could trim yields slightly.  Again, it's worth noting that TIPs are illiquid securities, so they are only crude proxies for real yields, and the spread between them and comparable Treasuries is but a rough-and-ready gauge of inflation-expectations.

Technical factors reportedly have pushed yields lower.  Mortgage investors and servicers apparently are aggressively hedging the prepayment risk in their portfolios by buying Treasuries, and thus exaggerating the downward move in yields.  But there is little way of knowing how big a factor this is. One can imagine hedge funds buying Treasuries in anticipation of a 'convexity trade' downdraft in yields, so no real hedging need take place.  A further dip in mortgage yields would add to the pressure on Treasury yields, especially if the GSEs rebalance their well-publicized asset-liability mismatch.  But a slackening in the near record-pace of mortgage refinancing activity would greatly reduce it, boosting yields again.

Two other factors have yet to affect Treasuries: First, soaring Federal budget deficits haven't stood in the way of declining yields, for obvious reasons.  In a sluggish economy, private credit demands are still soft. Corporate America's external financing needs are de minimus as rising cash flow is outstripping capex and inventory accumulation.  And consumers are saving more from current income, and deleveraging their balance sheets.  Second, the dollar's decline and capital outflows haven't led to upward pressure on yields, as growth concerns and disinflation are global issues.

This balance sheet of plusses and minuses helps answer some "what if" questions about yields, but doesn't really help forecast them -- unless we can confidently call the factors driving them.  What would?  When investors sense a real bottom for stock prices, we could probably call the bottom in Treasury yields.  In either case, we won't know it's the bottom until after the fact.