By Richard Leong and Ellen Freilich
NEW YORK (Reuters) - A rough couple of months in the U.S. bond market has lifted interest rates off record lows and now could impede a slow economic recovery heavily dependent on cheap money to keep going.
While stocks have surged to near-record levels from five years ago, an accompanying rally in the $11.6 trillion U.S. Treasury debt market appears to have run out of steam and bond prices have dropped steadily since early December. That has pushed up bond yields, which move in the opposite direction to prices and they are now at the highest levels since last spring.
Some of what's behind the sell-off can be seen as positive - greater investor confidence in riskier assets such as stocks, signs the European debt crisis is abating and a spate of U.S. economic indicators that point to more growth.
As bonds fall out of favor, however, credit-sensitive corners of the economy could start to feel the pinch. The housing market, car sales and business and public sector investment will be vulnerable as the cost of borrowing rises because all credit costs are ultimately tied to the Treasury market.
"I do fall into the camp of people who worry what will happen when rates go up," said Tom Nelson, chief investment officer at New York-based Reich & Tang, a firm with nearly half of its $28 billion in assets under supervision in money market mutual funds.
Of course, the demise of the three-decade bond-market rally has been forecast repeatedly in recent years. Just last March, Bill Gross, manager of the world's largest bond fund, the PIMCO Total Return fund, sharply cut his exposure to U.S. Treasuries. Bonds proceeded to rally through November, driving the yield on the benchmark 10-year Treasury note to well below 2 percent.
The threat of a major sell-off remains distant in many investors' minds because the market enjoys one big source of demand - the U.S. Federal Reserve. As part of its latest effort to prop up the economy by flooding the banking system with cash, the Fed has been buying $85 billion of Treasuries and mortgage bonds from banks each month since September and has no plans to ease up anytime soon.
Still, investors have grown more hungry for higher yields, driving investment fund flows into equities and away from bonds in the past couple of months. The Standard & Poor's 500 index has delivered a total return in excess of 6 percent since the end of November, while the return on Treasuries has been a negative 1.3 percent, according to Bank of America/Merrill Lynch Fixed Income Index data.
As a result, the 10-year yield last week rose to more than 2 percent for the first time in nine months. Expectations are for yields to move higher, at least modestly.
"This is the biggest risk for bond investors," Hans Mikkelsen, a bond strategist with Bank of America Merrill Lynch in New York. "I'm surprised we have gotten to 2 percent already."
In October, Mikkelsen forecast a "Great Rotation" from bonds into stocks in early 2013. Also, a survey last week by J.P. Morgan showed that one in four investors own fewer Treasuries than their portfolio benchmarks, the most in almost 19 months.
And ultimately, analysts agree the Fed's highly accommodative monetary policy must come to an end.
Nelson from Reich & Tang recalled 1994, when the Fed raised its benchmark federal funds rate six times, to 5.50 percent from 3 percent.
"When the Fed starts to raise rates, they're not going to go to 35 basis points," Nelson said. "There's a high probability that they will move faster than they did in 1994 because just getting back to neutral will mean a sharp rise in rates."
BANANA PEEL FOR HOUSING?
The spike in Treasury yields, from which most U.S. mortgage interest rates are derived, comes at a sensitive moment for a housing market that has just started gaining traction. Rising mortgage costs could slow investments in real estate, which contributed to economic growth in 2012 for the first time since the housing bubble burst five years ago.
The average interest rate on 30-year mortgages, the most widely held type of U.S. home loan, has increased by 0.15 percentage point to 3.67 percent, according to the Mortgage Bankers Association. That rate would probably have to rise to about 4 percent to hurt housing by discouraging investors from pouring more cash into the sector, analysts said.
Rapidly rising yields would also squeeze businesses and local governments looking to borrow to spend on building plants and roads or hire workers. Like mortgage rates, public and private borrowing costs are linked to Treasury yields.
Berkshire Hathaway Inc
DEJA VU ALL OVER AGAIN
Still, the bond market has seen this before. In the last two years, bond yields rose in the first quarter, only to fade by spring as growth slowed and Europe's debt crisis flared up.
"Each year we've had waves of optimism and pessimism. Right now, investors are on the optimistic foot," said Robert Tipp, chief investment strategist at Prudential Fixed Income in Newark, New Jersey.
Even if yields rise modestly, it is not bad for everyone. Banks would see profit margins improve as their short-term borrowing costs will likely remain near zero because the Fed is expected to stick to ultra loose monetary policy into 2015.
For savers who have seen their incomes dwindle, a pickup in interest on bank accounts and money mutual funds should be a relief and perhaps encourage them to spend a bit more.
Overall, economists do not think the ingredients are in place for more than a modest rise in rates in 2013. The economic growth trend is still spotty. Even an aggressive forecast would still not bet on Fed raising rates until somewhere in 2014.
"It's not the final bell for the bond market just yet, though it's getting closer," said Daniel Heckman, senior fixed income strategist at U.S. Bank Wealth Management in Minneapolis.
(Reporting by Richard Leong and Ellen Freilich; Editing by David Gaffen and Andre Grenon)