After declining pretty steadily since the end of July and hitting all-time lows on Monday, long-term Treasury yields have risen significantly this week in response to the massive hit the dollar took against the Japanese yen.

It isn't quite the reversal that it appears, however.

Certainly, the 30-year Treasury bond's yield has reversed course. After declining to an all-time low of 4.72% on Monday, it's currently trading over 5.10%.

But by another measure, long-term yields remain on the same course they've been on since midsummer. That course is toward a steeper and steeper yield curve, or a bigger and bigger difference between long- and short-term yields.

What's happening, market analysts agree, is that investors, having flushed the credit risk out of their portfolios by selling stocks and risky bonds, are also flushing the interest-rate risk out by exchanging long-term bonds for short-term notes.

What they don't agree on is whether that's warranted. And the difference seems to boil down to whether the U.S. economy is on the brink of recession or not.

The relationships of stocks, Treasury yields and the dollar appeared to change course this week after Japanese politicians reached an accord on major banking reform legislation. The resulting sharp drop in the dollar against the yen accelerated as leveraged investors scrambled to cut their losses on bets against the yen. To cover short positions, many sold long Treasuries, magnifying losses in that sector. At the same time, the weaker dollar stoked fear of higher inflation, since it will make imports more expensive. That prompted additional sales of long Treasuries, whose yields rise and fall with inflation expectations.

But while long Treasury yields reversed course, all the while that they'd been dropping, short-term yields had been dropping even more quickly. As a result, the difference between long and short yields had been widening, and the yield curve had been steepening.

Since late June, that is. Until late June, stock prices were rising, as was the dollar, and both long- and short-term yields were falling, with long yields falling faster, flattening the yield curve to as little as a 13-basis-point (0.13 percentage point) spread between the two-year Treasury note and the 30-year bond.

Everything changed

Over the course of the next two months, everything changed, as investors started pricing in a global recession rather than one contained in Asia. Stock prices went into decline, followed by the dollar about a month later as demand for dollar-denominated assets started to contract.

Short-term yields went into rapid decline below the fed funds rate, then 5.5%, pricing in a series of eases by the

Federal Reserve

and putting additional downward pressure on the dollar. The greenback's value is based partly on short-term yields, which track the fed funds rate.

But in spite of the sinking dollar, long-term interest rates stayed on their downward path. The reason: As investor flight from risky assets escalated, Treasury securities -- of any maturity -- became the only asset anybody wanted. Demand for safety and liquidity overwhelmed fundamental considerations about the value of long-term bonds at such low yields.

As long-term yields dropped to historic lows, however, short-term yields dropped so much more quickly that the yield curve kept steepening. It widened from 22 basis points on Aug. 22 to 67 on Monday. This week, it has exploded to 103 basis points, the steepest yield curve we've seen since March 1996.

That's the respect in which nothing changed this week. Long-term yields were dropping until Monday, and now they're rising, but since everything changed in midsummer, investors have consistently been asking for higher and higher relative long-term yields.

It's the latest leg of the flight to quality. But is it warranted? What happened to the dollar this week was almost certainly overdone -- the result of leveraged traders who've already sustained heavy losses in stocks and risky bonds being forced to cut their losses on bets against the yen rather than a reflection of a sudden, major change in the currencies' fundamental value.

Recession expectations grow

Conceding that,

Mellon Bank

chief economist Richard Berner still sees a fundamental reason for relatively higher long-term yields. "In the last three days, the perception that a recession might lie ahead has probably intensified," spawning "increased expectations for the Fed to ease sooner and more aggressively than people thought." Indeed, rumors apparently by way of

Johnson Smick's

Washington newsletter have the Fed easing as soon as today.

The rise in long-term yields also makes sense because they'd gotten so low, Berner said. "Once we got to those levels, which by anyone's estimation represented a market that was very overbought, I'm not sure it ought to be a surprise that in a volatile selloff we get bond yields bouncing back to 5%."

Moody's Investors Service

chief economist John Lonski, on the other hand, said this week's moves don't accurately reflect the strong condition of the U.S. economy. "What's quite amazing is to have the dollar fall sharply absent any evidence suggesting a worsening of any U.S. economic fundamentals vis-a-vis Japan," he said. "The direction may be right, but the magnitude is all wrong based on what the fundamentals call for."

In Lonski's estimation, corporate bonds didn't deserve the severe beatings they took this summer, and long-term Treasuries don't deserve their current treatment either. "What we've seen with the dollar and the corporate bond market underscores the extent to which recent moves may be much more a byproduct of extraordinary trading phenomena as opposed to telltale signs of changed fundamentals," he said.

If there's a recession, Lonski says, it'll be limited to the financial services industry -- unless the financial services industry is so badly wounded that it can't satisfy the huge increase in demand for mortgage credit that low long-term bond yields have produced. "I think you'd have to look hard for a recession that also enjoyed a housing boom," he observed. "I think a lot of the gloom you're hearing is because there's likely to be a lot of layoffs in the financial services industry."

Fleet Financial Group

chief economist Nicholas Perna isn't forecasting a recession either, or at least not a deep one. He notes that previous deep recessions "have been brought to you by huge ratcheting up of interest rates," whereas now interest rates remain at historic lows. "Stock portfolios are worth less, but bond portfolios are worth more," he observes.

But he says this week's repricing of the dollar may make a recession likelier by keeping the Fed from aggressively cutting rates to prevent one, for fear of accelerating the dollar's decline. "It couldn't happen at a lousier time," he said.