A U.S. Treasury market rally that has driven bond yields below the key inter-bank overnight lending rate may be the strongest signal yet from the bond market that the Federal Reserve has gone too far in its campaign to raise interest rates.

Bond market rallies that leave long-term bond yields below short term interest rates, resulting in an inversion of the normal yield curve, have often preceded economic downturns historically.

But only four other times in the last quarter century has the majority of the U.S. Treasury yield curve, from 2-year notes to 30-year bonds, slipped below the federal funds rate, the main U.S. interbank overnight lending rate.

Each instance preceded either a downturn in the economy, a major financial strain, or both, wrote Merrill Lynch's North American economist David Rosenberg in a research report on Monday.

Previous occasions included the late summer of 1998, when Russia defaulted on its debt and hedge fund Long Term Capital Management failed, and another example occurred in March of 2000 when technology stocks peaked before the 1990's stockmarket boom ended.

On past occasions what transpired on average over the next six months was a major rally in the bond market, led by the shorter end of the yield curve, a 25 basis point widening in corporate bond spreads, a 6 percent decline in commodity prices, and a sharp underperformance of small cap stocks, Rosenberg wrote.

Last week, the U.S. 30-year bond's yield joined other maturities of Treasury notes and bonds in falling below the federal funds target rate.

Economists also note indications of a potential economic slowdown from the stock market, where share prices have been trending lower since early May.

When you have both (bond yields and stocks)... moving in the same direction, it's a pretty strong signal that markets are worried that the economy is slowing, said Sheryl King, a senior economist at Merrill Lynch in New York.

ECONOMIC SLOWDOWN

U.S. Treasury yields falling below the federal funds rate may signal an economic downturn, or even recession, reinforcing an earlier signal from the overall inversion of the Treasury yield curve, in which short maturities yield more than long maturities.

On Tuesday in New York, two-year notes yielded 5.17 percent, 6 basis points more than 10-year notes, with both below the 5.25 percent funds rate.

The fact the whole curve is below the funds rate...can be interpreted as a sign that the market is becoming more pessimistic about the future growth outlook, said Lena Komileva, G7 market economist with Tullett Prebon in London.

The two-year note, which closely reflects market expectations for Federal Reserve monetary policy shifts, may be the strongest signal the bond market thinks the Fed may not raise interest rates much more, if at all.

That the two-year note is yielding less than the federal funds rate is clearly a sign from the bond market that the Fed is going a bit too far in the short run just to fight off inflation risks, Komileva said.

With a time lag, economic growth and inflation are now likely to subside, Komileva added.

The slowdown we are seeing now at the start of the third quarter is clearly the beginning of a sustained deceleration in growth...(and) will start materializing in a softer core inflation trend two years from now, she said.

FED WATCHING BONDS:

The fall of long maturity bond yields below the overnight lending rate may not just be a harbinger of economic slowdown, but also may be a cause, because it constrains the ability of banks to borrow for short maturities and lend profitably at longer maturities, thus inhibiting business expansion.

The yield curve is not telling us yet the Fed has overshot, but I think the Fed would be wise to take note of these movements, said Kevin Flanagan, fixed income strategist for global wealth management with Morgan Stanley in Purchase, New York.

If the gap between the 10-year Treasury note yield and the federal funds rate were to widen to 25 basis points or more, that might bode recession, Flanagan said.

If the central bank is confident core inflation pressures will become more muted in the months ahead, the Fed may heed the bond market and halt its rate rises now, Flanagan argued.

He sees parallels with the top of the last monetary policy tightening cycle in May 2000 when the Fed stopped raising the funds rate at 6.5 percent.

Then the core consumer price index and average hourly earnings continued to rise even after the Fed stopped raising interest rates, but these inflation gauges did peak roughly six to nine months later, Flanagan said.

The Fed could in fact start cutting interest rates as early as 2007, some economists expect.

The market is signaling that the Fed has raised rates too much and is probably right. It's more likely that the Fed's next move is a cut and not a hike. We have pencilled in the first cut at the beginning of 2007, said Merrill Lynch's King.

We believe that they are done for the year. The June hike was the last one, King added.

Inflation is always a lagging indicator: it often continues to rise well after the economy has slowed and the Fed is not going to chase that up now that it is convinced that the economy is slowing and will remain slow.

Russia Inflation Merrill Lynch