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Will Rising Bond Yields Set Back the Stock Market?

While some traders fear rising bond yields could crimp stocks' gains, some bond strategists do not expect interest rates to rise beyond the range of the past year.

Treasury Building
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Treasury Building

"We look at 2011 as a trading, not trending year," said William O'Donnell, who heads rates strategy at RBS. He expects the 10-year yield to stay in a range of 2.75 percent to 4 percent, the top of its 2010 range.

"I know the economy is percolating along. Our economic staff does not think it's sustainable at the pace we've seen in the last couple of months," he said. Some of the worries are a possible, further 7-10 percent decline in housing prices, high unemployment and now, rising gasoline prices, he said.

Higher rates caught the attention of stock traders once more this week, as a thinly traded bond market saw rates ricochet higher and lower, around two Treasury auctions Tuesday and Wednesday.

First, the Treasury's 5-year auction Tuesday suffered from seriously weak demand, kicking off bond selling and triggering a resulting inverse move higher in yields.

Treasury yields then relaxed going into Wednesday, as buyers moved in, and finished the day lower after a strong showing at the Treasury's $29 billion 7-year auction.

The 10-year ended Wednesday with a yield of 3.37 percent, well below Tuesday's 3.48 percent close, and very near where yields began a volatile trading day Tuesday morning. The 10-year yield again edged higher to 3.4 percent Thursday, after a much stronger-than-expected Chicago purchasing managers' report.

Peter Boockvar, equities strategist at Miller Tabak, said aside from this week's action, the recent backup in rates since November is indicative of more to come.

"I think the violence of the move is pretty telling. It's not like this is a small market. It's a multi-trillion dollar market, trading like an internet stock, which is pretty amazing. It tells me there's a definite change here," he said. "The main theme in 2011 is that it's the bond market more than anything that will determine how equities go. There's nothing that can spoil a party in equities more than higher interest rates."

Wells Fargo Advisers chief equities strategist Stuart Freeman, however, does not see rates as an issue for stocks going into next year. "If you move up to 4 percent or even 4.25, perhaps that's something that's going to be more of an issue," he said. He expects the 10-year to be at 3.5 percent at the end of 2011, but he says that level could be surpassed if the economy proves stronger than expected.

In fact, the stock market may benefit as investors reduce bond positions, he said. That rotation is starting to show up in mutual fund flows. ICI reports that equity mutual funds saw inflows of $335 million last week, breaking a 33-week losing streak.

New Yield Range

Pimco senior strategist Tony Crescenzi said the success of the 7-year auction was not a surprise, and it is not really indicative of much. "The 7-year was cheap on the yield curve...It doesn't mean the market looked cheap, but that issue was particularly cheap," said Crescenzi. "I wouldn't get crazy happy about the market because of the 7-year because historically, it's always been an ugly duckling."

"It seems like the market is settling in on its new trading range, which for now seems to be 3 to 3.5 percent (10-year yield), and it's trading in the upper band of the new range," he said. Crescenzi expects the range on the 10-year to be roughly 3 to 4 percent in 2011, though it is possible it could slip back below 3 percent.

"Early in the year, the economy is likely to be strong enough to keep people romanticizing about the idea of both higher inflation and a rate hike, and that'll prevent the yield from declining below 3 percent," he said.

While much of the wild action in bonds may be over for the week, O'Donnell said the year end may spur some buying before the end of Friday as traders square positions, and that may generate some more volatile moves just because volume is so light.

A Thin Market

Deutsche Bank economist Joseph LaVorgna said the bond market's action this week was probably not reflective of much more than a thin year-end market. "At the end of the year, you get these moves and you don't want to read too much into them," he said.

Outside the New York Stock Exchange in lower Manhattan.
Photo: Oliver Quillia for CNBC.com
Outside the New York Stock Exchange in lower Manhattan.

While many strategists believe rates are rising on an improving economy, others, like Boockvar, believe rates are rising on inflation concerns.

"Rates are not going up for a good reason. It's inflation expectations, and of course you're getting higher interest rates in Europe for debt and deficit concerns, and you have rates going up in Asia because central banks are raising rates and they're worried about inflation. You'll probably see a rate hike in Taiwan tomorrow night. Last week, Brazil raised inflation expectations, and the central bank indicated they would raise rates in January," he said.

"Whether it's inflation, deficits or growth, the bottom line is they're still going higher and that'll be a challenge for equities, and again it will matter most for the areas of the world, where they're more indebted, like the U.S. and Europe," Boockvar said.

He said the problem with higher rates is that the economy has been depending on cheap money. "Higher interest rates are enough to impact things. You now get a move to 4 percent in the 10-year, and you're going to see 5.5 percent mortgage rates. While that's still historically low, that's a lot higher than where they were, and what's scary is the Fed didn't want that to happen," he said.

Rates have moved higher since the Fed began its $600 billion Treasury purchase program in November. The Fed next week is expected to buy up to $27 billion in Treasury securities and as much as $2.5 billion in TIPS in five days of purchases. This week, it only came to market on two days.

"We have to remember the Fed's buying program ends in June. What's going to happen going into that when everyone knows it's going to stop. Just imagine what's going to happen when everyone knows you're taking the 800-pound gorilla out of the market," Boockvar said.

LaVorgna said ironically the Fed's program could have created market volatility. In theory, the so-called "quantitative easing" program was intended to keep interest rates low and to reflate asset prices, by driving investors into riskier investments. He also said he didn't agree with the Fed's decision to embark on the easing program.

"I think the Fed's operations have become less relevant to the market. The market is ignoring the Fed because other things have become more important," he said, noting the Fed could be acting at odds with a market that is driving rates higher on expectations. Rates had moved sharply lower after quantitative easing was first discussed by Fed Chairman Ben Bernanke in late August. The lowest rates of the year were in October, before the market turned.

LaVorgna also believes the equities market can take rising rates in stride. "I think the bias is to higher rates as the market starts to realize the economy is going to be healthier and that's 3.75 to 3.80ish (10-year yield) range," he said.

"If Q4 earnings are solid and equities rally that would put further pressure on rates," he said. Stocks could react at about a 5 percent 10-year yield, but not in the mid-3 to just above 4 percent yield range, he added.

Questions? Comments? Email us at marketinsider@cnbc.com

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