Commentary > Bid and Ask
Don't fear rising rates
Rising bond yields and Fed rate hikes might not damage stocks this time around.
December 3, 2003: 8:48 AM EST
By Justin Lahart, CNN/Money Senior Writer

NEW YORK (CNN/Money) - With the economy going full throttle, it's become increasingly difficult to think the Treasury market won't go through a period of suffering. For investors, the question is whether trouble in bond land will set off sympathy pains in the stock market.

Although Treasurys are well off their highs of the year, rates remain remarkably low considering what the economy has been doing. The 10-year Treasury yield, at 4.38 percent, has bounced back to where it was in mid-2002 -- a period, you'll recall, that didn't seem nearly as rosy as now.

The two-year note has a yield of 2.06 percent, which, safe as it is, seems a lousy rate of return in an economy that grew at 8.2 percent in the third quarter and is expected to grow north of 4 percent over the next year.

The reason yields are low, of course, is that Fed officials have been saying they believe they can keep the overnight funds rate low for a long time. But the bond market may come to question the Fed's word -- or consider that "low" could still be considerably above the current rate of one percent -- in the days to come. Friday's November jobs report looks as though it could be quite strong and many observers believe the Fed will tweak the language it uses in the statement it will release at the end of next Tuesday's meeting to reflect an economy that's warming up nicely.

When bond yields rise stocks usually suffer. But in the current context this may not be the case.

First off, one of the things rising rates typically signal is a Fed that is in the midst of (or that the bond market believes should be in the midst of) trying to cool a too-hot economy. Since the Fed usually succeeds when it does this (and often succeeds too much), it's a strong indication that earnings are going to slow.

But this time around, a rise in rates wouldn't signal an attempt to cool the economy, but merely an effort to get rates up to the low side of normal.

A second reason rising yields usually hurt stocks is that they make stocks less attractive. If you could get, say, a 10-percent annual return on the 10-year Treasury -- a security that's backed by the full faith and credit of the United States of America -- why would you buy anything else?

But yields might have to climb a long way before they draw much interest away from stocks. The Fed model, a valuation tool that is decried by bears but still widely followed, says that the 10-year yield would need to rise all the way to 5.7 percent for it to really begin to attract investors.

Meantime, M.S. Howells chief market strategist Brian Reynolds points out that reason Treasury yields have remained so low is that many investors are still shunning risk.

"People have been conditioned to think rising bond yields are bad, and historically that's been true," he said. "But they're forgetting how bad falling bond yields were in 2002, when investors were selling stocks for the safety of Treasurys. They've been hiding in Treasurys ever since."

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As it becomes clear that even the Fed believes the economy is out of danger, those investors are going to pull money out of Treasurys and put it other places, including stocks. Rising rates won't bother stock investors until the 10-year yield hits somewhere north of 5 percent, thinks Reynolds -- maybe even 5.5 percent.  Top of page

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