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Supply-Side Hit to T-Bonds

THE U.S. WILL PAY A STEEP price for its stimulus program. As Congress continues to assemble a fiscal package whose total is reaching $900 billion and the Obama administration is set to unveil its bank-rescue plan, Treasury-note yields have moved up sharply ahead of the massive escalation in borrowing needs.

Indeed, the Treasury and stock markets reacted perversely to Friday's news of the biggest monthly decline in payroll employment since 1974. Bond prices fell and their yield racheted up while stocks rallied as the horrible news on the jobs front further stepped up pressure to enact a substantial stimulus program.

While the equity markets anticipated that this massive government spending would lift growth and profits, the Treasury market has to deal with the job of financing it. This week, it faces a record, $67 billion quarterly refunding.

That helped send the yield on the benchmark 10-year note to 2.99%, up nearly 100 basis points (a full percentage point) from early January and up 20 basis points from a week earlier. Meantime, the 30-year bond yield ended Friday at 3.70%, up 10 basis points on the week and up 109 basis points from its low just before year-end.

To put those moves in perspective, the iShares Barclays 20+ Year Treasury Bond exchange-traded fund (ticker: TLT), which tracks the long end of the market, has lost 16% since Dec. 30. Even after the worst January on record, the Standard & Poor's 500 SPDRS (SPY) are off only 2.25% over that span, with a boost from last week's 5% advance.

Meanwhile, the short end of the Treasury market has been anchored by the Federal Reserve's policy of targeting the federal funds rate in a range of 0-0.25%. Even so, the two-year note yield has moved up about 25 basis points, to 1%.

That has resulted in a much more steeply sloped yield curve, popularly defined by two points -- the two- and 10-year notes. The spread between them is up to nearly 200 basis points, about half again as much as at the turn of the year.

The traditional inference from this yield-curve steepening has been that the market anticipates economic recovery, higher inflation or both. Most real economists -- as opposed to those who play one on TV -- dismiss that interpretation.

The Economic Cycle Research Institute's Future Inflation Gauge fell to a 50-year low in January. The employment data show a shocking collapse, with the loss of 3.6 million jobs in the past year, a third of them since September, when the bottom fell out of the credit market with the collapse of Lehman Brothers.

The more plausible explanation of the backup in long-term Treasury yields has been the market's fear of excess supplies of securities. That has translated into an increase in the cost of insuring U.S. Treasury debt for five years to a record 82 basis points Friday, up 15 basis points in a day. (That means it costs 82,000 euros annually to insure €10 million worth of Treasuries for five years, up from €7,000 on Thursday. Credit-default swaps on U.S. debt are quoted in euros, given the ability of the government to print dollars to pay its obligations.)

The Fed has said it would consider buying long Treasuries to bring down their yield. The bond vigilantes are daring the U.S. central bank to follow through on its word.