T-Bond Rally Is Set Back; Dow Falls 21 : Markets: Yields soar as Greenspan’s remarks deflate investors’ hopes that the Fed was less worried about inflation.

The biggest rally in the Treasury market in three months suffered a major setback Wednesday after Federal Reserve Board Chairman Alan Greenspan delivered a stern warning that more interest rate increases may be needed to rein in inflation. Stocks also followed bond prices lower.

Bond yields soared and prices plunged as Greenspan’s remarks deflated hopes among fixed-income investors that the central bank had become less nervous about the U.S. economy’s rate of expansion.

The yield on the government’s main 30-year bond rose to 7.54% from 7.46% on Tuesday. Its price, which moves in the opposite direction, dropped 7/8 point, or $8.75 per $1,000 in face value.

On Wall Street, stocks followed bond prices lower, with the Dow Jones industrial average finishing down 21.04 points at 3,727.27.

In his first of two Congressional appearances this week, Greenspan told Senate Banking, Housing and Urban Affairs Committee members that interest rates may need to move higher to ensure that inflation remains in check.

“It is an open question whether our actions to date have been sufficient to head off inflationary pressures and thus maintain favorable trends in the economy,” Greenspan said.

So far this year, the Fed has pushed up short-term interest rates by 1.25 percentage points in four steps between February and May. Although the fixed-income markets have expected the central bank to push up rates again, analysts said, Greenspan’s aggressive tone caught many investors off guard.

“The view is he is coming out slightly more hawkish than he was expected to,” said Dana Johnson, head of market analysis at First Chicago Capital Markets in Chicago.

The selloff abruptly reversed one of the biggest market rallies since the bond market turned bearish in early February, when the Fed initiated the first of the four interest-rate increases.

Bond prices had jumped sharply since last Tuesday, driving down yields more than one-quarter percentage point following news on the economy suggesting there was no serious threat of inflation.

But it appeared the effect of those suggestions was undermined by Greenspan’s remarks.

The tumbling government bond market, however, did not deter California from selling tax-free securities.

California sold $4 billion in short-term notes Wednesday in the first stage of a $7-billion borrowing. The tax-free notes, known as revenue anticipation warrants, are short-term securities issued in anticipation of future revenue such as taxes.

The California sale came just days after major Wall Street credit-rating agencies downgraded the state’s debt. The majority of the notes sold Wednesday were backed by an innovative financing plan that reassured investors as to the state’s ability to pay money owed on the notes.

On Wall Street, many stocks were buffeted by quarterly earnings reports and weaker recommendations by analysts.

In the broader market, declining issues outnumbered advancers by about 2 to 1 on the New York Stock Exchange. Big Board volume totaled 268.04 million shares, compared to 251.54 million for the previous session.

The NYSE composite index fell 1.19 to 249.70. The Nasdaq index of mostly smaller issues fell 6.55 to 712.77. The Standard & Poor’s 500-stock index dropped 2.26 to 451.60.

“Today was a shakeout day,” said Don Hays, director of investment strategy at Wheat First Butcher Singer. “We think people are quick to sell on any news.”

Other analysts said the stock market frequently overreacts to Greenspan’s statements and that stocks could well be in for a rise to recoup the day’s losses.

Among the market highlights:

* Compaq Computer Corp.’s second quarter earnings were in line with forecasts, but some analysts said its product inventories were high. The stock dropped 1 3/4 to 31 1/2.

* Software maker Sybase Inc. lost 8 1/2 to 39 3/4 despite reporting a rise in earnings. Bear Stearns lowered its rating to “neutral” from “buy.”

* Pfizer dropped 2 to 60 1/8 after reporting higher profits but with the expectation that its 1994 earnings will come in toward the bottom of Wall Street estimates.

* Illinois Central Corp. fell 1 3/4 to 30 5/8 after the company said it planned to buy Kansas City Southern Industries’ Kansas City Southern Railroad. Goldman Sachs downgraded Illinois Central, saying the deal will dilute its earnings.

* Mid Atlantic Medical Services fell 6 1/8 to 41 3/4 after an analyst cut the stock to “neutral” from “buy.” Mid Atlantic had reported sharply higher earnings earlier in the day.

* Alcoa fell 1 3/8 to 80 5/8 after Oppenheimer & Co. downgraded its opinion of the stock.

* USAir, which reported a rare profit for its second quarter, rose 1/2 to 7.

* AMR fell 1 1/2 to 61 3/8. The American Airlines parent company said its profit after a special gain was $1.49 per share, well below analysts’ expectations.

* DSC Communications, which reported sharply higher second quarter earnings, rose 5/8 to 23 7/8.

* Sifco Industries gained 1/4 to close at 3 after reporting that it had reversed its loss of a year ago to earn $17,000 for the second quarter.

Foreign markets were mixed. Stocks finished broadly lower in London, with the Financial Times 100-share average falling 14.1 points to 3,077.2; Frankfurt’s 30-share DAX average closed 9.86 points higher at 2,138.65.

Tokyo’s Nikkei average ended up 5.60 points at 20,780.76, and Mexico City’s Bolsa index fell 44 points to 2,210.95.

Meanwhile, the dollar fell slightly against key currencies, following the bond and stock markets.