Bouncing Bonds Bedevil Stocks

Gyrating Treasury prices have caused confusion on the Street. Here's what the fixed-income market is telling equity investors

Equity players are paying close attention to the doings of their bond-market brethren. In recent weeks, the bond bears have come out roaring. PIMCO Chief Investment Officer Bill Gross last month raised his stake in cash equivalents to the highest level since February, 2005, moving assets away from the debt markets. And the manager of the world's biggest bond fund wasn't the only fixed-income guru singing the blues.

Sure enough, Treasury prices declined sharply in the wake of a Feb. 21 report showing higher inflation (see, 2/21/07, "Consumer Prices Heat Up"). The 10-year note ended lower for two straight sessions as yields pushed higher. And the weakness in bonds—and prospects for higher interest rates—unnerved equity investors as well, spurring a retreat that knocked the Dow Jones industrial average off its record perch.

But the bond market is nothing if not mercurial. On Feb. 23, geopolitical concerns involving Iran's nuclear program helped bonds turn around. The price on the 10-year note climbed 13/32 to 99-18/32 in afternoon trading.

Boom or bust for bonds? Some fixed-income observers expect a dramatic move either way, with potentially wide-ranging implications for stocks. Falling bond prices would drive interest rates higher, possibly crimping corporate spending. The prospects of a wider Mideast conflict or weaker-than-expected U.S. economy could raise concerns of their own for Wall Street. The upshot: Uncertainty in the bond patch can keep equity investors at bay.

Contagious Pessimism

To be sure, the latest change in fortunes might not reverse bonds' broader downward trend. Renewed inflation worries, shifts in foreign financial flows, and unfavorable technical patterns could signal a pullback for bonds, some analysts say, following a few years of range-bound Treasury prices. Alternatively, cooler economic data or flight to safety amid Iran worries could help keep the debt markets afloat.

Some bond bears worry that infusions of liquidity from overseas may finally be drying up. "Stocks, credit spreads, and yes intermediate and long term bonds relative to a likely unwavering Fed Funds rate in 2007's first half, may stagger shortly," Gross says in his February investment outlook. As of Jan. 31, cash and equivalents accounted for 43% of assets in his $99.9 billion PIMCO Total Return Fund's (PTTAX) portfolio, up from 26% a month earlier.

However, China's decision to diversify away from Treasuries isn't necessarily bad news for bonds or the stock market, other analysts reckon. "They don't want the dollar to plunge," says Ed Yardeni, chief investment strategist at Oak Associates, in a Feb. 16 report. "So they will continue to accumulate dollars in their international reserves portfolio."

Hikes or Cuts?

A continued rise in inflation, on the other hand, could damage the markets. Entering 2007, the bond market braced for the Federal Reserve to start cutting rates at some point this year. But consumer prices are nudging up, and minutes of Fed meetings indicate that policymakers are concerned enough about inflation that a rate cut probably isn't in the cards anytime soon.

Bond investors may have to adjust to rate hikes, not cuts, according to Jack Adkins, director of quantitative strategy at research group Action Economics. Technical indicators, too, point toward a drop in bond prices, Adkins says. "Chart patterns suggest that the bond market bears will prevail in 2007, as yields posture for an upside breakout," he notes in a Feb. 21 report.

On Mar. 1, Wall Street will get a January reading for the Fed's preferred inflation gauge, the personal consumption expenditures (PCE) price index. This report could be "unfriendly," warns Goldman Sachs economist Seamus Smyth in a Feb. 22 note to clients.

That's because medical costs, which posted their steepest increase in more than 15 years in the recent CPI report, are weighted more heavily in PCE.

Inflation Target

In fact, the Fed may have painted itself into a corner, says David Rosenberg, chief North American economist at Merrill Lynch. Rosenberg expects the Fed to start cutting rates in the second half of the year. "Not until core PCE and CPI show signs of dipping below—and staying below—the 2% mark can we expect to see this Fed switch gears, but we still expect this to occur in the second half of the year," he says in a Feb. 22 report.

The housing market remains a trouble spot for the economy. Homebuilder Toll Brothers (TOL) recently issued a disappointing forecast for first-quarter revenue. HSBC Holdings (HBC) and New Century Financial (NEW) have warned of problems in the subprime mortgage market. Fellow mortgage lender Novastar Financial (NFI) posted a fourth-quarter loss amid subprime credit woes (see, 2/22/07, "A Painful Hiss from the Subprime Balloon").

Higher bond yields could increase the headaches for mortgage lenders, some market pros say. "The fixed income market could show the way from here," says Steen Jakobsen, chief investment officer at Saxo Bank, in a Feb. 23 report. Jakobsen says his strongest position is a short—a bet on a price decline—on fixed income.

What to Watch

At the same time, other analysts see money moving back into the bond market from stocks. "There is talk of asset reallocations at work out of equities and into [fixed-income securities]," say economists at research group Ried Thunberg in a Feb. 23 note to clients.

Nervous investors may want to consider defensive plays. A majority of sectors received more analyst downgrades than upgrades over the past week, according to a Merrill Lynch report. The exceptions: health care and consumer staples.

The fears of PIMCO's Gross and other bearish bond investors may be confirmed, or the worst could have already come and gone. While bonds' ultimate direction is still uncertain, stock investors would do well to watch the bond market carefully.

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