Stocks, Bonds Feeling Gross

"Now you have a few contrary indicators who turned coat on their dovish bond market call, and if anything, it is a good sentiment indicator that makes the case that the sell off may cool temporarily," says Michael Darda, chief economist at MKM Partners. Overally, Darda believes investors should be getting out of bonds and into equities, but suggests waiting here for a small Treasury rally to sell into.

Technically, sentiment in the bond market is approaching its most bearish levels as well, according to Rich Ishida, chief technical analyst at Market Vane. His "bullish consensus" reading on bonds fell to 44% Thursday from 48% on Wednesday, which he calls a "large drop." The trough in bullish consensus on bonds over the past two years was May 2006, when the reading hit 41%. The peak was 65% in November 2006.

Just last fall, Gross wrote that "the U.S. bond bull market, which began almost two months ago, remains in its infancy." Now in his latest "Secular Forum" posted on Pimco's Web site Thursday, he says that the yield on the 10-year Treasury bond could reach 6.5% within the next five years, up from a 5.5% top of the range previously.

Gross adds that inflation in the U.S. could creep up to average 3% over the next three to five years, which he characterizes as an "upward drift" in terms of his outlook. High commodity prices and a shift in financial fund flows away from long-dated Treasury bonds are key factors leading him to change course.

It may be time to agree with Gross as the bond market rights the ship to accept lower odds of recession or rate cuts. But most observers do not expect the 10-year Treasury yield to soar much farther, even from a fundamental perspective.

The notion of no looming fed funds rate cuts may push the 10-year yield toward 5.25%, even with the fed funds rate, writes Tony Crescenzi, fixed income strategist at Miller Tabak and RealMoney.com contributor. But moving higher than that would require strong evidence of rising inflation. Right now the Fed's preferred measure of core inflation is running at 2% -- the top end of the central bank's comfort zone.

Yields "will be restrained by the lack of concrete justification for an interest rate hike in the same way that yield declines of the past year were limited by the lack of Fed rate cuts," he writes. "Long rates should stabilize unless rate hike bets grow."

If the Treasury market does calm down, the stock market will have to decide which direction to head in as well.

There may be more underlying strength in the stock market than most realize, says James Paulsen, chief investment strategist at Wells Capital Management, who notes the lack of panic selling and no massive rush to defensive stocks.

Paulsen also points to relatively stronger performance by some of the "high beta" tech names amid Thursday's rout. Apple(AAPL Quote) gained 0.4%, as did Advanced Micro Devices(AMD Quote). Netflix(NFLX Quote) gained 5.9% on news of a possible merger with Amazon(AMZN Quote), which fell 0.6% on the day.

If stocks and bonds do stabilize short term, the test will be if just one slightly troublesome inflation reading could pull the rug back out from under the markets, Paulsen says.

Fortunately for traders, they have just the Commerce Department's report on April's trade deficit to worry about tomorrow. The next inflation data appear next Thursday and Friday with the producer and consumer price indices.

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