Beware the toxic mix of falling stocks and rising Treasury yields

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Stocks slumped Monday and Treasury bond yields rose, which is a combo that really gives Wall Street the creeps.

The damage was limited -- the Dow Jones industrials lost 104.22 points, or 1%, to 9,867.96, and the 10-year T-note yield (charted below) ended at 3.55%, up from 3.47% on Friday. But if this turns into a trend it could undermine investor confidence in a hurry.

Why? Stocks, of course, are a bet on economic recovery. If the market sells off because of recovery concerns, Wall Street fully expects Treasuries to benefit -- meaning, yields should fall as some investors seek a haven.

Unless . . . investors stop regarding Treasuries as a haven, perhaps because of the ever-ballooning federal debt.

Investor demand for Treasuries had been robust in August and September even as the stock market rallied. But for the last seven months the Treasury market also has had the benefit of regular purchases by the Federal Reserve, which on March 19 committed to buying $300 billion of government bonds in an effort to put a lid on longer-term interest rates.

Those purchases will end this week as the Fed reaches its self-imposed $300-billion limit.

While the Fed prepares to step away the Treasury is coming to market with another huge slate of debt to sell: It will auction $44 billion of two-year notes today, $41 billion of five-year notes on Wednesday and $31 billion of seven-year notes on Thursday.

It isn’t unusual for market yields on Treasuries to back up a bit ahead of auctions. That may be the simple explanation for the recent rise in interest rates, which left the 10-year T-note yield at a two-month high on Monday.

George Goncalves, head of fixed income rates strategy at bond dealer Cantor Fitzgerald in New York, thinks there’s still enough private investor demand for Treasuries to soak up the ongoing flood of supply without a steep jump in yields.

Some big investors, he says, have been simultaneously putting money to work in the bond market at opposite ends of the spectrum: They’ve been buying corporate junk bonds for yield, while also buying Treasuries for the liquidity they should provide if markets were to enter another panic phase.

But Tom Tucci, head of government bond trading at RBC Capital Markets in New York, says a lot of the investors his firm deals with aren’t much interested in Treasuries at current yields, which are well below their peak levels of spring.

‘With people now very neutral on the market given where yields are, supply becomes an issue again,’ Tucci said. And the Fed won’t be there after this week to take up some of that supply.

Wall Street can understand the logic of the combination of falling stock prices and falling Treasury yields; ditto for the combo of rising stock prices and rising bond yields.

But in a still-struggling economy, falling stocks and rising Treasury yields would signal that something has gone very wrong.

-- Tom Petruno