BondsThe long run of steadily declining Treasury yields may have ended.

In trading Thursday, the yield on the two-year Treasury note poked back above the federal-funds target of 2.25%, something that’s rarely happened in the past three years. Furthermore, the two-year note’s yield of late is higher than the expected federal-funds rate six months from now, a dramatic reversal from a trend that has persisted since March 2005.

This could be the watershed, the inflection moment we’ve been waiting for,” says George Concalves, chief Treasury and agency strategist at Morgan Stanley. “We’ve been so tightly wound up in rates because of strong flight-to-quality flows, which was justified cause people trying to figure out where the problems were with the banks. Now, we’ve seen that come off.”

The two-year note no longer trades below the expectation for fed funds six months out. (Source: Morgan Stanley)

Of late, the two-year note was traded with a yield of 2.34%. For most of the past three years, the two-year note’s yield has been trading anywhere from 0.25 percentage point to 0.5 percentage point below the expected federal-funds rate six months down the road as determined by federal-funds futures contracts. Bond investors were worried about the specter of a severe slowing in economic growth and were running ahead of the expectations for monetary policy.

“People had priced in a lot of bad news,” says Thomas Roth, head of Treasury trading at Dresdner Kleinwort. “No one wanted to buy anything but Treasurys. They weren’t concerned about return on principal, just return of principal.”

That started to change in December, when the Federal Reserve announced the formation of the Term Auction Facility to assist in lending to banks. By then, the difference between the two-year note’s yield and the expected funds rate had widened to about 0.75 percentage point. It started to reverse, but still held below the anticipated Fed target through the first four months of the year.

It has now broken above that level, which Mr. Concalves says may hasten the exits from low-yielding Treasurys to riskier investments. It also suggests greater concern about inflation, and the low-yielding two-year note currently does not compensate investors in the case of high inflation.

“There’s going to be uncertainty on the inflation front over the next two years,” Mr. Concalves said. “Companies that were exporting deflation are now exporting inflation. As an investor, 2% is not going to cut it — it’s hard to justify Treasury rates at these low levels.”