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IT'S THE CRASH YOU DIDN'T HEAR. Not in the price of any security market, but in short-term U.S. Treasury yields.

Treasury bills once again were trading at negative interest rates Thursday, a mind-boggling state of affairs that hasn't existed since the panic late last year. That followed the collapse of Lehman Brothers and the assorted knock-on effects, notably the run on money-market funds after the Reserve Fund "broke the buck."

More significantly, the yield on the two-year Treasury note -- the most actively traded security on the planet -- fell to 0.669% Thursday, within a hair of the low of 0.657% set in the dark days of last December, according to data on Barrons.com's Market Data Center.

But now, the economy is supposed to be well on the way to recovery, in contrast to late last year when it seemed we stood on the precipice of a second Great Depression. The Dow is back above 10,000 and bulls claim all's right with the world. Why, then, would any rational investor be willing to lock up money for two years for the paltry return of less than two-thirds of 1%?

Wacky things have happened before in the T-Bill market. Over the turn of the year from 2008 to 2009, investors were so skittish about where they stashed their cash that they effectively paid Uncle Sam to hold it, resulting in negative yields on T-bills. Other times have seen odd happenings in the T-bill market, usually during times of stress when investors wanted only the safest assets.

Unlike T-bills, which have only weeks to run until maturity, the two-year note embodies market expectations for interest rates. Longer-term yields are simply the sum of successive short-terms; all else being equal, you should earn the same from two consecutive one-year notes as a two-year note. Nobody knows what the future holds, of course, so what the second year will yield is just a guess.

What a two-year yield of 0.70% (where the note ended Thursday) means is that the market believes short-term rates won't rise much for a long time. The 12-month Treasury rate is just 0.25%, so the market implicitly expects the 12-month rate a year hence would be 1.15%, all else being equal. (The sum of 0.25% and 1.15% averages out to 0.70% over two years.)

Considering that the two-year note yield was 1.40%, exactly twice as high in early June, that's a big comedown in expectations. And it's down sharply -- by nearly a third -- from just a month ago, when it was around 1%.

What's incongruous is the confluence of miniscule short-term Treasury yields with the stock market sitting at its highest perch in the past 13-plus months. If the recovery and the bull market are for real, who would settle for such niggardly note yields? Especially if the Treasury is about to auction another $118 billion of notes next week?

Part of the reason relates to diminishing expectations of the Federal Reserve to raise interest rates any time soon. In a speech Wednesday, St. Louis Fed President James Bullard pointed out that the federal-funds rate target typically isn't raised for 2 ½-to-three years after the end of a recession.

Bullard added that the slowness with which the Fed raised rates in recent cycles -- which helped inflate the housing bubble last time -- will weigh heavily on the Fed's deliberations this time around. And, as head of the monetarist-oriented St. Louis Fed, he emphasized that the central bank may rein in the expansion of the central bank's balance sheet as a first step in removing accommodation. Increasing the fed-funds rate may come later.

The bond market heard mainly the last part of the message, and is pricing in a continuation of the current 0-0.25% fed-funds target—if not all the way to 2012, as Bullard's observation about Fed behavior suggested—but well into the second half of 2010. As recently as early November, the fed-funds futures market had priced in a rate hike as soon as next July.

But look no further than the latest mortgage data for a clue about what the Fed is apt to do. One in 10 mortgage borrowers is at least one payment behind schedule in the third quarter, according to the latest numbers released Thursday by the Mortgage Bankers Association. Add in the nearly 4.5% of mortgage borrowers who are actually in foreclosure and you find that one in seven American homeowners with mortgages is in serious trouble.

Given this level of debt distress, the likelihood of the Fed raising rates dwindles to insignificance until well into 2010 and perhaps beyond.

And this may be like the proverbial butterfly flapping its wings on the other side of the globe, but the opposition Labour Party in New Zealand this week withdrew its support for its central bank's policy of targeting inflation as its touchstone.

The significance of that is the Reserve Bank of New Zealand was the first central bank to adopt inflation targeting back in the 1980s. That was a part of the tiny nation's free-market reforms championed by Finance Minister Roger Douglas that came to be called "Rogernomics," which outdid Reaganomics in the States.

One academic became an enthusiast of the Kiwis' inflation targeting -- Ben Bernanke. Other central banks followed the New Zealanders, if not as formally, then in practice.

The tide is turning against inflation targeting now that inflation is nil or negative in many countries. Kiwi Labour leader Phil Goff called for a "competitive" exchange rate for the New Zealand dollar, which has surged 23% against the U.S. dollar in the past six months, Bloomberg News reported, which is anathema to an export-dependent economy.

In a less dramatic fashion, this is an updated version of William Jennings Bryan's famous "cross of gold" speech in 1896. During deflations, there is no political will to pursue zero-inflation policies.

In similar fashion, that means the Fed will likely maintain a rock-bottom fed-funds target as long as the debt deflation exemplified by mortgage delinquencies foreclosures persists. That's the message of the two-year Treasury note. And it isn't a bullish one.

Comments: randall.forsyth@barrons.com