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Could Fed Lose Control of 10-Year Yield? KBW Asks the Question

NEW YORK ( TheStreet) -- With 10-year U.S. Treasury yields jumping more than 10% since Wednesday's Federal Open Markets Committee meeting, a report from investment bank Keefe Bruyette & Woods raises an ominous question: "What If the Fed Loses Control of the 10-Year Yield?"

The report got my attention because, late on Tuesday, I published an interview with Parsec Financial chief economist Jim Smith, the most bearish of 71 forecasters surveyed by Bloomberg in his forecast for where 10-year yields will finish the year. Smith forecasts a year-end 10-year yield of 3.76%, but even though that is considerably higher than Thursday's levels of 2.40%, Smith does not believe the Fed will lose control.

I argued that because Smith doesn't see the Fed losing control, one might conclude that none of his peers on the Street do either. On the other hand, I pointed to the paper published in February by four prominent economists, including ones at Deutsche Bank and Morgan Stanley who did not participate in the Bloomberg survey, that does sound the alarm on the threat of interest rates spiking far too sharply for anyone's comfort.

Now we have another investment bank raising this question -- not via its chief economist, but by Christopher Mutascio, an analyst who focuses on large-cap bank stocks.

He is concerned that a sharp rise in the long bond will curtail mortgage banking income, and he focuses on three banks -- Wells Fargo (WFC - Get Report), Fifth Third (FITB - Get Report) and SunTrust (STI - Get Report) that saw the highest level of mortgage banking income as a percentage of total revenue in the first quarter of 2013. Most exposed of these is Fifth Third, argues Mutascio, because it looks to get the smallest offset from mortgage servicing income.

But given the broad market declines we've seen in the past two days, seeing the Fed lose control would have a much larger impact than anything Mutascio addresses in his report.

Also worrisome is Mutascio's hypothesis that rising yields might not merely be an indication of an improving economy.

"Many investors seem to believe that if the Fed starts tapering, then it must be a sign of a strong economy. But, what if the Fed believes it needs to start tapering because it is concerned about the potential for asset bubbles? In other words, QE may now be doing more damage than good. If that scenario plays out, then the Fed could potentially end QE even though the economy is not as strong as we would all like it to be," Mutascio writes.

Mutascio isn't an economist, you might observe. What does he know? But as I pointed out in Tuesday's article, market economists forced to stake their reputations on where the 10-year bond will finish the year may not be in the best position to think outside the box.

-- Written by Dan Freed in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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