Deficit Package Has Yin-Yang Effect on Stocks, Bonds : Economy: President’s program shows how forces that rally the fixed-income markets can send shivers through Wall Street.

If investment markets are any measure of a nation’s mood, then the United States is suffering from a case of manic depression.

Bond investors popped the champagne last week--as stock enthusiasts reached for their anti-depressants.

A single factor provoked the divergent responses: President Clinton’s deficit-busting package of higher taxes and reduced spending.

While the fixed-income and equity markets rarely react precisely in unison to economic developments, last week’s dramatic attitude split illustrated some fundamental differences in the nation’s two best-known investment vehicles.

The bond market’s rally was based on the expectation that Clinton will be able to persuade Congress to pass his deficit-reduction package.

Investors also liked the prospect that economic growth will be restrained by Clinton’s proposed sacrifices.

Conversely, stocks got clobbered on fears that his new taxes will stifle corporate profits, putting the brakes on an already sluggish economic recovery.

Still, experts say the markets could be getting far ahead of themselves.

With months of uncertainty before Congress makes a decision on the plan, individual proposals could be substantially diluted if voters decide they won’t put up with tax hikes or cuts in their favorite programs.

“The stock market is reacting as if the increased taxes are going to throw the economy into a recession,” said C. Frazier Evans, senior economist for Colonial Mutual Funds.

“The bond market is taking an exceptionally positive view of all the news but hasn’t considered that there is still a very profound gap between outlays and revenues that has to be closed.”

Clinton’s sales pitch mentions the bond market rally, where investor euphoria drove the yield of the Treasury’s long bond to an all-time low of 7.02% by last Thursday, the day after his historic address to Congress.

Bond investors welcome a lower deficit because it means the federal government will have to sell fewer bonds to cover expenses, thus reducing supply and boosting the value of existing securities.

While recent presidents have vainly pledged to prick the deficit balloon, Clinton came up with some credible-sounding details on how to cut $140 billion from the projected deficit by fiscal 1997.

“In the past there’s always been lambs in wolves’ clothing. Now we’ve come up against a guy who seems serious,” said Tim Rogers, a money market economist with Technical Data, a Boston research firm.

Citing the bond market’s positive response as proof, Clinton says his plan to slash the federal deficit will help bring down interest rates and ultimately make borrowing cheaper for Americans.

In addition, bond buyers favor slow economic growth because it will presumably keep a lid on inflation, which in the long run can erode the value of fixed-income securities.

“The market has gone about as far as it can go on belief and hope and expectation. To go any further it has to see hard numbers. In other words, Congress has to begin to enact things that don’t make the plan any less deficit-reducing,” said Bruce Steinberg, an economist at Merrill Lynch & Co.

Moreover, as Congress signals its intent on passing specific programs, the next few months may return the two markets to more parallel paths. For example, the prospect of higher taxes could threaten bonds as well.

The President is asking for a new 36% maximum income tax rate for individuals and a 10% surtax on ordinary taxable income above $250,000.

Higher marginal tax rates mean investors need larger yields to match their investments. Higher bond yields result in lower prices.