Late Thursday, amid a wicked selloff in Treasuries, legendary bond fund manager Bill Gross of

Pimco

declared that bonds are now in a bear market. A contrarian might say Gross' bombshell revelation means the Treasury market might just stabilize soon.

If bonds find their range, the mystery is what will stocks do? Only then will it be clear if market participants were just going through an attitude adjustment based on belief in a stronger-than-expected economy, or if investors really believe inflation and rate hikes are necessary.

In the meantime, Gross' words in the late afternoon Thursday helped push the 10-year note down 1 5/32, its yield rising 5.12%, its highest level since July 2006. That, in turn, pushed stocks down sharply, with major averages ending near their lows of the day.

The

Dow Jones Industrial Average

slumped 1.5%, or 199 points, to close at 13,266.73, while the

S&P 500

broke below 1500, down 1.8% to close at 1490.72. The

Nasdaq Composite

fell 1.8% as well, to close at 2541.38.

All 30 stocks in the Dow ended the day in the red, led by losses of 2% or more by

Alcoa

(AA) - Get Report

,

3M

(MMM) - Get Report

, and

Microsoft

(MSFT) - Get Report

.

Gross' capitulation on the direction of bond yields follows a

change of heart among a handful of the most bearish economists and strategists on Wall Street who had been holding out for

Federal Reserve

rate cuts. From a contrary indicator perspective, Gross is the pinnacle, though he still believes the Fed will cut rates later this year.

"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) - Get Report

gained 0.4%, as did

Advanced Micro Devices

(AMD) - Get Report

.

Netflix

(NFLX) - Get Report

gained 5.9% on news of a possible merger with

Amazon

(AMZN) - Get Report

, 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.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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