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As bond prices dip, stockholders fret

With earnings season in full swing, investors’ attention has been firmly focused on stocks. But turmoil in the bond market has stolen much of attention on Wall Street in recent days.
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With second-quarter earnings season in full swing, investors’ attention has been firmly focused on stocks of late. But turmoil in the bond market, which typically plays second fiddle to the equity market, has stolen much of the attention on Wall Street in recent days.

Indications of a more upbeat assessment of the economy from the U.S. Federal Reserve has led to a sharp sell-off in U.S. bonds and pushed the yield on the benchmark 10-year Treasury note up over one percentage point from a 45-year low hit in mid-June. Yields rise when bond prices fall.

The rise in yields has led some investors to ask if the three-year rally in government debt is over. And there are broader concerns for stocks and the economy. Higher bond yields can choke economic growth by raising borrowing costs, potentially crimping the economic rebound that stock investors were betting on this spring.

A catalyst for the month-long sell-off in bonds was the Fed’s modest rate cut last month, which appeared to suggest that the U.S. central bank’s concern about deflation may have been overstated. Deflation is a period of broad price declines not seen in the United States since the Great Depression.

This view was reinforced by commentary last week from Fed Chairman Alan Greenspan, who in his semi-annual testimony before Congress downplayed his earlier comments about the threat of deflation and said he expects the economy to strengthen in coming quarters.

“I think Greenspan’s testimony last week was a seminal event [for the market],” said Steve Massocca, head of trading at Pacific Growth Equities. “He took a fair amount of people on Wall Street by surprise and created a significant uptick in bond yields.”

In his testimony, Greenspan suggested that unconventional methods to counteract deflation would only be used as a last resort. Prior to that, traders had bid up bond prices, assuming that the Fed was close to taking the unusual step of buying Treasuries in the open market.

Higher yields hurt stocks
After a sharp sell-off in bonds earlier this week, investors are wondering what the implications are for the stock market and the overall economy.

Prices plunged Monday, pushing the yield on the 10-year bond to its highest level since early December. They reversed some of their losses on Tuesday and Wednesday, after a Federal Reserve policy maker said the U.S. central bank would be prepared to cut short-term interest rates all the way to zero, if necessary, to prevent an economically-crippling fall in inflation.

A worry on Wall Street has been that higher bond yields could suck money out of the stock market, eroding a rally of some 23 percent since mid-March, said Massocca.

The Standard & Poor’s 500-stock index, a measure of the overall stock market, has been wavering since hitting its highest levels in about a year in mid-June, just as interest rates began to rise. The Dow Jones industrial average has followed a similar pattern.

“Money hasn’t moved out of equities significantly, but the market has moved off its highs. Second-quarter earnings have been good, but until the interest rate situation stabilizes, or reverses, it’ll hold back the market,” Massocca added.

Economic recovery in question
Another concern voiced by some market observers is that higher bond yields point will result in rising consumer interest rates, which could crimp the fragile economic recovery.

But other analysts contend that interest rates are still relatively low compared with historical levels and may have fallen much further than they should have in May after the Fed warned of the possibility, although slim, that deflation may put the kibosh on the economic recovery.

David Greenlaw, chief U.S. fixed income economist at Morgan Stanley, told CNBC he thinks we’re close, but not yet at the point where higher interest rates could trouble the economic recovery.

“I don’t think the move that we’ve seen to this juncture is going to have a meaningful impact on the housing markets or other credit intermediation. But if we go further than this there’s a chance of spill-over into the economy,” Greenlaw said.

The prospect of stronger economic growth has also put pressure on bonds.

On Monday, the Conference Board said its Index of Leading Economic Indicators, which aims to predict economic activity, posted its third straight monthly rise in June, suggesting an economic recovery is at hand.

“I think that a significant part of what we’re seeing in the bond market is a reassessment of the economic situation,” said Steve Stanley, an economist at RBS Greenwich Capital.

Stanley argues that whereas the stock market has rallied strongly since mid-March, as traders have bought up stocks, betting on an improving economy and rising company earnings in the latter half of the year, the bond market has now come to the same realization.

“So in a sense the stock market guys were out ahead of the bond market; they were more forward-looking,” said Stanley. “But now that the economic numbers are starting to show some growth, the question is has the stock market already priced that in?”

Mortgage market a factor
Bond yields help determine mortgage rates, and higher mortgage rates could slow home sales and refinancing — two bright areas in the nation’s otherwise spotty economic recovery.

Indeed, observers say selling pressure in the bond market has come from mortgage-related hedging activity in the huge U.S. mortgage market, which has had an increasing impact on the U.S. government bond market in recent years.

Institutional investors who own mortgages and usually buy Treasuries to hedge their positions in case interest rates fall and set off more mortgage refinancing are selling their positions as the refinancing threat eases.

Reuters contributed to this story.