Low bond yields: Fuel for stocks?

Experts say stocks are growing much more attractive compared to bonds. Others say low yields will drive stocks lower.

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By David Goldman, CNNMoney.com staff writer

Click chart to view latest bond prices
Click chart to view latest bond prices

NEW YORK (CNNMoney.com) -- The Federal Reserve hoped that low bond yields would help heat up the housing market and consumer lending, but low yields may also have helped to ignite the stock market.

After announcing last week that the government will buy back its own debt over the next six months, Treasury yields, which move in a direction opposite to prices, have fallen near three-month lows.

Bond yields fell further by the end of trading Thursday, as the government completed a three-day debt auction totaling a record $89 billion and stocks rallied.

Although that may be good for borrowers of loans tied to bond yields, investors can't like the measly earnings they're due to receive on their holdings.

To be sure, stocks' earnings yields aren't much to write home about, either: The 12-month trailing earnings-per-share yield is just 5.6% versus an average of 5.5% for the past 21 years, according to Sam Stovall, chief investment strategist at Standard & Poor's.

But the earnings yield, which is measured by taking the reciprocal of a stock's price-to-earnings ratio, serves as a good guide to stocks' relative attractiveness to bonds. So 5.6% looks great compared to the 2.8% that the benchmark 10-year bond is yielding.

"The yield factor, in terms of risk, is much more attractive in the stock market, and that is a factor in the recent rally," said Peter Cardillo, chief market economist at Avalon Partners. "By the end of the quarter, that could help drive the S&P up to 850 [from its current level of 814], which would be very encouraging. Anything above that would suggest we made a bottom."

But other experts say that low yields could actually lead stocks down. As yields fall, U.S. assets become less attractive to foreign investors, leading to a decline in the dollar and lower profits for U.S. businesses.

"Stocks won't perform well in a deflationary environment, because companies will be forced to cut prices, which will ultimately drive profits lower," said Antonio Sousa, senior currency strategist at Forex Capital Markets. "We're not going to get out of this environment in 2009; people are looking forward to 2010."

Treasury yields have fallen near the all-time lows that they hit in December - the time when the last stock market rally ended and market indexes plunged to 12-year lows. Sousa says he thinks the current stock rally will suffer a similar fate.

But Stovall and Cardillo believe the stock market will ultimately head higher after withstanding earnings season, led higher by relative attractiveness to Treasurys, which held the title of "only attractive buy for investors" for the past six months. With yields this low -- which could remain low for the six-month duration of the Fed program -- stocks may appear attractive as well.

Bond prices: Bonds prices rose Thursday after another $24 billion auction in 7-year notes, bringing the total for the week to a record $89 billion.

Thursday's auction drew more than $60 billion worth of bids for the $24 billion offered. That made for a bid-to-cover ratio of 2.51, reflecting healthy demand. Last month's auction of 7-year notes had bid-to-cover ratio of 2.11.

The government sold $34 billion in 5-year notes on Wednesday, and $40 billion worth of 2-year notes Tuesday.

The benchmark 10-year note was up 13/32 at 100 2/32 and its yield fell to 2.74% from 2.79% late Wednesday.

The 30-year bond gained 1 21/32 to 97 11/32 with a yield of 3.64%, down from 3.74%.

The 2-year note advanced 3/32 to 99 30/32, and yielded 0.9%.

The 3-month yield held at 0.15%.

Lending rates: The 3-month Libor rate was unchanged from Wednesday at 1.23%, according to data on Bloomberg.com. The overnight Libor rate also held steady at 0.29%.

Libor, the London Interbank Offered Rate, is a daily average of rates that 16 different banks charge each other to lend money in London.

Two credit market gauge were relatively unchanged. The "TED" spread held even at 1.04 percentage points. The narrower the TED spread, the more willing investors are to take risks.

The Libor-OIS spread moved higher to 1 percentage point from 0.99 points on Wednesday. A narrower spread indicates that more cash is available for lending. To top of page

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