Rising Long Bond Yield Didn't Deter the Dow from 10K

But a move by the Fed to raise short-term rates could spoil the outlook.
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In the end, the Dow didn't need the long bond to conquer 10,000.

Long-term interest rates have risen about 15 basis points in the last week and a half. In other words: since the

Dow Jones Industrial Average

made its initial run at the millennial mark.

At the time, it looked like the long bond was propelling stocks higher. For most of the year, its yield had been rising, helping to keep stocks rangebound. But on March 5, a cooler-than-feared February

employment report

convinced the bond market that it had become far too worried about the prospect that the

Fed

would raise interest rates. From that day until March 18, the long bond's yield shed more than 20 basis points to 5.49% from 5.70%, and the two-year Treasury note went to 4.98% from 5.20%. (Traders price the two-year note based on their expectations for the Fed, which last fall lowered the fed funds rate three times, ending with it at 4.75%, and hasn't touched it since.) March 18 was the day the Dow closed at 9997.62.

The long bond's yield has crept higher since then, chiefly because oil prices have kept rising from their February trough. But perhaps because long-term yields have risen, taking pressure off the Fed to raise rates, the two-year note's yield is still right around 5%. And obviously, that's right where the stock market likes it.

The scene may change Tuesday. The Fed's monetary policy committee will hold its second meeting of the year. And while it is widely expected to leave interest rates unchanged, fewer people will be surprised if the committee ditches its presumably neutral bias in favor of an official bias in favor of a higher rate -- and announces the change shortly after the meeting concludes at 2 p.m. EST.

Either way, some of the short-term credit for Dow 10,000 goes to the short end of the bond market. (It's beyond dispute that over the long term, gradually falling long-term Treasury yields have been a principal driver of the Dow's ascent.)

So? Are we going to be thanking the bond market -- long and short -- for Dow 11,000 any time soon?

Inflation Could Return. Really. Maybe.

Skeptics say that at some stage, rising stock prices will force the Fed to act by threatening to reignite inflation. Tony Crescenzi, the chief bond market strategist at

Miller Tabak Hirsch

, whose

predictions for 1999 have so far been among the more prescient, recently sent a dispatch to clients calling Dow 10,000 bearish for bonds.

Dow 10,000 makes it "unlikely that the U.S. economy will slow on its own," Crescenzi wrote. He said a strong stock market signals to the

Fed

that investors believe the dangers from the global crisis have passed; solidifies recent improvements in global financial conditions; lowers the cost of capital for companies, which encourages more capital spending; and emboldens consumers to keep spending at a torrid pace.

"By default, higher rates

are the only way," Crescenzi wrote.

There's broad agreement that rising stock prices help drive economic growth. But it's lonelier to argue that the growth will ultimately fuel inflation, because inflation has been in decline throughout the expansion, which is in its ninth year.

To thinkers who believe that technology-driven productivity growth and global overcapacity will allow noninflationary growth to continue indefinitely, Dow 10,000 is essentially meaningless. "Interest-rate markets, the Treasury market specifically, have shown that they can live with a strong equity market," said

Morgan Stanley Dean Witter

money-market economist Kevin Flanagan.

What makes it interesting is that bond bears and bulls concede each other's points to a degree. Bears recognize that capital spending, while driving economic growth, can also improve productivity, controlling inflation. Meanwhile the bulls can't fully shake the fear that the old economic models will spring back to life as stock prices rise -- that if consumer spending doesn't moderate, demand will catch up with supply and inflation will rise.

They'll have to duke out over what to make of the fact that long-term bonds tanked on the Dow's big day. Are they in the process of spelling doom for the rally, or allowing it to continue by taking the pressure off the Fed?