What a Week: Bond-Bound

Stocks' fortunes rose and fell with the 10-year Treasury's yield.
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As the markets soared to new heights in April and May, the mantra among many market participants was, "I'm looking to buy a 3% to 5% dip."

That dip came fast and furious this week, amid rising Treasury yields and "sudden" concerns about inflation and the potential for

Federal Reserve

rate hikes. In response, major averages suffered a three-day swoon that chopped about 400 points, or 2.9%, off the

Dow Jones Industrial Average

, 49 points, or 3.2%, off the

S&P 500

, and about 77 points, or 2.9%, from the

Nasdaq Composite

.

The selling culminated with Thursday's near 200-point Dow drop and, true to their word, many managers did step into the resulting breach on Friday. The Dow jumped 157.66 points, or 1.2%, to 13,424, the S&P added 1.1% to 1508 and the Nasdaq jumped 1.3% to 2574.

Friday's gains were aided by better-than-feared results from

National Semiconductor

(NSM)

, which gave other chip stocks a boost; speculation of a possible takeover of

U.S. Steel

(X) - Get Report

; news of a

Tyco

(TYC)

corporate restructuring; and strong global sales at

McDonald's

(MCD) - Get Report

.

But the real trigger for Friday's rally was the same as the catalyst for the prior selling: action in the Treasury market.

After touching 5.25% early Friday, the yield on the benchmark 10-year Treasury retreated to 5.12%, quelling fears of rising yields -- for one afternoon at least -- and paving the way for the stock market's rebound, which pared the weekly losses for major averages.

For the week, the Dow lost 1.8%, the S&P shed 1.9% and the Nasdaq fell 1.5%, the worst weekly performance since the late-February swoon.

The 10-year Treasury note, meanwhile, rose 16 basis points this week, its worst weekly price performance in two years, according to

Bloomberg

. Yields on the two-year note rose 3 basis points to 5%, while the yield on the 30-year bond rose to 5.21%. (Treasury yields move inversely relative to price.)

Higher Treasury yields prompted a reassessment of the relative attractiveness of stocks vs. bonds, fueling the midweek selloff, which was most intense in rate-sensitive financials like

Goldman Sachs

(GS) - Get Report

, utilities like

Exelon

(EXC) - Get Report

and housing-related stocks like

Pulte Homes

(PHM) - Get Report

.

But bullish strategists are sticking to their forecasts.

"We believe valuation is still quite attractive with our trailing P/E vs. bondyields and equity risk premiums model still intimating a very bullish sign for positive market appreciation over the ensuing 12 months 100% of the time, looking back 45 years," writes Tobias Levkovich, chief U.S. equity strategist at Citigroup.

Levkovich, who recently raised his 2007 target for the Dow to 14,400, says "previous panic readings

on his proprietary sentiment model argue for attractive market gains in the next six months with better than 90% historical probability."

Michael Darda, chief economist at MKM Partners made similar comments on Friday's

The Real Story podcast, saying Treasury yields would need to approach 6% before really threatening the stock market.

"Our valuation work shows that stocks remain about as cheap

relative to bonds as they were expensive during the year 2000," he says.

Speed Kills

Friday's recovery aside, this week's action shows what happens on Wall Street when expectations change quickly. In this case, the change was over perceptions of the

Federal Reserve's

presumed next move.

Odds of a Fed rate cut this year have come down from 100% five weeks ago to 48% two weeks ago to 0% today. Meanwhile, odds of a 2007 rate hike have risen to 40% vs. a 0% chance a month ago.

The "no rate cut, possible rate hike" pendulum swing picked up speed this week, as ISM Services, weekly jobless claims, inventory data and the trade deficit all pointed to renewed economic vigor. Meanwhile, a downward revision to first-quarter productivity and upward revision to unit labor costs revived concerns about inflation.

It's actually a bit of a misnomer to say financial markets fear inflation. The markets fear policy makers will take action in response to rising price pressures, and that rate hikes will crimp economic growth, cut off the liquidity that has propelled global stocks to record heights and curtail debt-financed private-equity buyouts.

This week saw rate hikes by the central banks of Europe and New Zealand. On the home front, Fed officials continued to express concern about inflation, with chairman Ben Bernanke saying price pressures are ebbing but remain "somewhat elevated."

Bernanke also said residential housing "appears likely to remain a drag on economic growth for somewhat longer than previously expected," but other Fed speakers reiterated the central bank's predominant concern: inflation.

"Since 2005, the three- to five-year moving average of U.S. inflation has hovered around 3%," said Cleveland Fed President Sandra Pianalto. "This is above where I would like to see the trend settle in the longer run."

Speaking about rising commodity prices, Pianalto added, "there is a risk that the public's trust could erode and inflation expectations could move higher."

Overshadowed by drama in the stock and bond markets, gold tumbled $26 this week, copper prices fell 4.3% and gasoline futures fell 5.2% from their recent peak amid higher-than-expected inventories. But crude hit a nine-month high above $67 per barrel this week before retreating Friday.

Aaron L. Task is editor at large of TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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to send him an email.