End Of The Bond Rally?

There is a nice article over at the WSJ MarketBeat Blog discussing how the recent run of declining Treasury yields may be nearing an end. For the first time in about three years, the yield on the 2-year Treasury note is above the current federal funds rate of 2.25%. Maybe more important, the Treasury rate is also above the 6-month federal funds futures rate. Of course, a few days with a positive spread is good news, but it does not make a trend. Nonetheless, it is encouraging.

Does this bode well for the stock market? Can we assume that people are selling Treasuries and dipping their toes back into the stock market waters? Does this signal the end of the rate cuts, or at least imply that the best we can hope for is a 25 bp cut next week? Maybe, but maybe not. Investors are selling Treasuries, but it may be for reasons other than sector rotation. Given increases in inflation, yields on Treasuries are now low enough that investors are not being properly compensated for the risk of higher inflation. Furthermore, even with lower rates, Treasuries were attractive in a falling stock market if for no other reason than to preserve capital, even with low returns. When inflation increases and rises above your rate received, suddenly your buying power begins to decrease. As such, the recent move from Treasuries (to munis, money market funds, TIPS, corporates, equities - take your pick), may have more to do with inflation, and less to do with attractive new risk/return yields, at least in the short-term. If the spread continues to grow, we may begin to start feeling more confident that a shift in the market is occurring.