Is It Time to Bond? : Yields Edging Down Slowly While Stocks Recoup Losses

Has Wall Street turned the corner, after a dismal winter and early spring?

Without much fanfare, many investors are seeing their stock and bond assets rise in value once again, if at a snail’s pace:

* Bonds have been appreciating as market yields have slowly edged lower since May 9, after rocketing almost nonstop since late January.

The 30-year Treasury bond yield, the benchmark for long-term interest rates, has dropped to 7.26% now, after surging from 6.35% at year’s end to 7.65% as of May 9. Yields on other types of bonds also have edged lower.

* The stock market, taking a cue from bonds, has rallied modestly since mid-May, raising hopes for the proverbial “summer rally” on Wall Street.

The blue-chip Standard & Poor’s 500-stock index, which slumped 5.2% between Jan. 1 and May 9, has gained 3.6% since. And the Dow Jones industrial average, at 3,755.91 at Tuesday’s close, has recouped all of its losses and now is slightly above its year-end close of 3,754.09.

The credit for the markets’ healthier tone, of course, goes largely to the same entity responsible for driving investors into a selling frenzy earlier in the year: the Federal Reserve Board.

The Fed’s decision to begin tightening credit on Feb. 4, for the first time in five years, was the equivalent of yelling “fire!” in a crowded movie theater. By raising short-term interest rates from 30-year lows, the central bank in effect booted speculators out of the stock and bond markets, and focused bond owners in particular on the idea that the economy was growing fast enough to reignite inflation.

But just four months after the Fed’s policy shift, the principal goal of that shift--to slow the economy to a moderate pace, with low inflation--appears to be working. Or at least, that’s what the Fed apparently believes.

In public and private statements over the past few weeks, Fed officials have strongly projected the idea that they’re satisfied with their decisions so far this year, and that they’re comfortable leaving short-term interest rates alone for the foreseeable future.

On Wall Street, the promise of stability has proved to be a powerful tonic. A key moment for the markets occurred last Friday, when the government reported a sharp drop in the May unemployment rate, but stock and bond markets failed to view the report as a reason to resurrect old worries about too-fast economic growth and inflation. Bond yields actually edged lower on Friday.

With the Fed’s recent soothing tone, “The market is accepting that these yields (on bonds) are appropriate for the likely events in the economy” over the near-term, says Kevin Logan, economist at Swiss Bank Corp. in New York.

Peter Anderson, president of money manager IDS Advisory Group in Minneapolis, notes that the market isn’t just taking the Fed at its word. Despite the puzzling unemployment report, many of the economic indicators reported in recent weeks have suggested “that the economy is slowing just a tad,” Anderson notes.

In addition, the bond market has been helped by other factors, Anderson says. A plunge in grain and soybean prices over the past week, as much-needed rain fell on the dry Midwest, has helped further reduce inflation worries.

And a strengthening dollar has given foreign investors new incentive to buy U.S. bonds and stocks, because each increase in the dollar’s value causes foreigners’ assets here to appreciate.

Even so, many experts caution investors against expecting a sharp decline in long-term interest rates from current levels. More likely is that yields will trade in a narrow range for at least a few months, until it’s clear that the economy is either slowing further, accelerating again or continuing to grow at the same moderate pace.

Swiss Bank’s Logan, for example, figures the 30-year Treasury bond yield, now 7.26%, will bounce between 7.1% and 7.6% this summer as traders push the market to and fro, alternately starting rallies and then selling into them.

William Gross, a principal at bond giant Pacific Investment Management Co. in Newport Beach, figures the T-bond yield range this summer will be 7% to 7.5%. “There’s probably not going to be a lot of excitement in the bond market, relative to what we’ve seen” in recent months, Gross says.

For many bond investors, a lack of excitement would be welcome, after the losses incurred in the market in winter and early spring. But experts also caution investors to use this period of relative calm to assess whether they should stay in bonds. If the economy accelerates again later this year or in 1995, interest rates could surge again, causing more principal losses for bond owners.

Some pros worry that the next shock to the bond market will happen sooner rather than later. Alfred Kugel, investment strategist at Stein, Roe and Farnham in Chicago, expects to see some “un-rallying” in the bond market over the next two months, with yields jumping again.

“We think some of the economic and inflation numbers ahead will be a little stronger than the consensus view now discounts,” Kugel says. The first such test could come Friday, when the government reports on wholesale inflation in May.

But if the consensus view is in fact correct--and the economy continues to moderate--what are the smartest bond market investments today?

Many bond pros say the high-yield “junk” corporate bond market is a good bet, because junk yields haven’t dropped in line with yields on Treasury bonds since mid-May. “I think the high-yield market is in great shape fundamentally and technically,” says Frederick Cavanaugh, manager of the $410-million John Hancock Strategic Income fund in Boston.

For a simpler bet, Pacific Investment Management’s Gross says investors should look at intermediate-term Treasury securities. The yield on 5-year T-notes, for example, is 6.52% now. At that level, Gross says, the market is assuming that the Fed will raise short-term interest rates another full percentage point or more by year’s end. If the Fed doesn’t take that strong a step (Gross doubts they’ll have to), then there’s room for 5-year T-note yields to come down, Gross says.

What about the stock market? Anderson of IDS says the market may be about to replay the cycle of the last two years, only in condensed version.

Bank and other financial stocks have already rallied over the past month, he notes, as bond yields have fallen. The next move, Anderson says, should be in some of the economy-sensitive stocks that have been beaten down hardest since winter--autos, retailers and airlines, for example.