Bonds Looking Better to Wall St.

Wall Street may be taking a page from Hollywood’s playbook: If you can’t find a great new story, bet on a remake of an old one.

Doubts about the economy and worries about terrorism drove some investors out of stocks and into government bonds last week, in a shift reminiscent of the market pattern that dominated from mid-2000 through 2002.

By Friday, the year-to-date return on the nation’s biggest bond mutual fund, Pimco Total Return, was more than twice the gain of the biggest stock fund, Vanguard 500 Index.

As Federal Reserve policymakers prepare to meet Tuesday, more investors are questioning what until recently had been considered a certainty -- that the central bank would begin to tighten credit this year and send interest rates higher across the board.

Falling bond yields show that market players increasingly believe “that Fed rate hikes [are] now months away and might even slip into 2005,” said Tobias Levkovich, equity strategist at Citigroup Global Markets Inc. in New York.

Most analysts expect the Fed on Tuesday to reiterate its statement from the January meeting, when policymakers kept their key short-term rate at a generational low of 1% and said they could be “patient” with rates, pending a stronger economy.

The January statement caused a stir because the language was different from previous statements in which the Fed had pledged to keep rates low “for a considerable period.” The change seemed to cement the idea that investors should be preparing for higher rates.

But in February, some data suggested that the pace of the economic rebound was slowing. And on March 5, the government’s report that the economy added a net 21,000 jobs in February, a number far below expectations, triggered a steep drop in bond yields as investors rushed to buy fixed-income securities to lock in returns. (As bond prices rise, yields decline.)

The yield on the 10-year Treasury note, a benchmark for other long-term rates, tumbled to an eight-month low of 3.85% on March 5 from 4.02% the previous day.

“Financial markets have started to worry about the downside risks to the U.S. economy,” said Jan Hatzius, an economist at Goldman, Sachs & Co. in New York.

Early last week Treasury yields continued to slide, with the 10-year T-note reaching 3.73% by Wednesday.

Instead of helping the stock market last week, falling bond yields hurt by siphoning money away from equities and by raising fears that a slower economy would undermine corporate earnings.

By the close of trading Wednesday, the Dow Jones industrial average had lost nearly 300 points, or 2.8%, over three sessions.

Then came the terrorist attacks in Madrid on Thursday. Investors fled stocks, driving the Dow down 168 points in heavy trading, and money again poured into bonds, sending the 10-year T-note yield down to 3.69%, the lowest since July 11.

On Friday markets calmed somewhat. The Dow rebounded 111.70 points to 10,240.08, and the 10-year T-note yield rose to 3.78%.

Still, many stock investors’ heady gains of January have been sharply pared or wiped out. The Vanguard 500 Index fund, which tracks the blue-chip Standard & Poor’s 500 index, now is up 1.1% this year.

Meanwhile, the Pimco Total Return fund, which owns mostly high-quality bonds, is up 2.5% for the year.

Stocks had trounced bonds in 2003 as Wall Street bet on a stronger economy, and by year’s end most analysts were predicting more of the same in 2004.

A big question now is whether the Madrid attacks will cause more investors to shy away from taking risks in stocks and boost the attraction of government bonds, even at what are historically low rates.

If yields fall further, the effect could be to encourage a rush to lock in rates, analysts noted. The allure of bonds also could grow if economic data weaken further, which could spur expectations that the Fed might cut interest rates in desperation.

A few more months of poor employment data “and rest assured, the market will soon be talking about the next [Fed] move being an ease” of credit, said David Rosenberg, an economist at Merrill Lynch & Co. in New York. “Shades of the summer of 2002.”

Other factors also are helping the bond market at the moment. For example, Asian central banks continue to be big buyers of Treasury securities as they recycle wealth generated by their trade surpluses.

What’s more, owners of mortgage-backed bonds often snap up Treasuries as interest rates in general decline. That buying is tied to expectations that mortgage refinancings will rise, causing mortgage bonds to be retired earlier than anticipated.

Nonetheless, most Wall Street pros warn investors against becoming too pessimistic about the economy or the stock market.

Although the pace of the recovery is ebbing, “a severe slowdown still seems unlikely,” said Goldman’s Hatzius. Consumer and business spending have remained strong, and Americans overall are seeing bigger federal tax refunds this year because of the Bush administration’s tax cuts.

As for stocks, many analysts say the latest pullback was overdue after the market climbed with no significant interruptions from mid-March of last year through January.

At worst, stocks are facing a typical “bull market correction,” said Tom McManus, investment strategist at Banc of America Securities in New York.

First-quarter corporate earnings, which will dominate the business headlines in a few weeks, are expected to be robust. Data tracker Thomson First Call’s latest analyst survey pegs year-over-year first-quarter earnings growth for the S&P; 500 companies at 15.1%, based on companies’ results from continuing operations. That’s up from the 13.4% rise analysts were predicting two months ago.

Some economists continue to warn investors away from bonds, despite their seeming renewed appeal.

“If I were running the Fed, I would have tightened rates already,” said Scott Grannis, an economist at Western Asset Management in Pasadena. “We think they’re falling behind the curve, and the longer they wait, the more they’re going to have to tighten eventually,” particularly if inflation rises.

At some point, “the bond market is going to be blindsided,” Grannis said.