An inflation alarm on Wall Street yesterday sent stocks tumbling and interest rates soaring, with the Dow Jones Industrial Average falling 199 points to 13,267.
The Dow has lost more than 400 points, or nearly 3 percent, in the past three days, spooked by a sudden worldwide rise in bond rates that was set off by intensified inflation pressures in the United States and elsewhere.
The Standard & Poor’s 500 Index also has dropped nearly 3 percent and has fallen back through the 1,500 barrier to 1,491 yesterday in a frenzied day of trading with nearly 2 billion shares changing hands.
The downturn comes after all the major indexes hit record highs during May on hopes that inflation was declining enough to enable the Federal Reserve to keep interest rates stable or consider cutting them to nurture economic growth. Those hopes largely disappeared Wednesday, when a report showed a jump of 1.8 percent in wage costs at U.S. employers and a weak productivity gain that was not sufficient to offset the renewed wage pressures.
The news sent the yields on Treasury 10-year bonds vaulting to 5.13 percent yesterday — the highest in nearly a year. Also stoking the move was a surprise interest rate increase by the New Zealand central bank yesterday that put investors all over the world on alert that the campaign against inflation remains alive.
“The threat of inflation is raising long-term rates” and triggering a reallocation of stock and bond investments worldwide, said J. Bryant Evans, a portfolio manager with Cozad Asset Management in Champaign, Ill.
What spooked stocks was not just the large jumps in inflation and long-term rates, but a major realignment or “normalization” of interest rates that for the first time in a year left long-term rates above the level of short-term rates, he said. That repositioning means that investors are expecting both higher inflation and interest rates.
Fed Chairman Ben S. Bernanke and other Fed officials this week warned that prices still are rising too quickly, with some fretting that the rapid rise of fuel prices this spring could touch off another inflationary spiral.
U.S. stock and bond markets were largely unprepared for the possibility of higher interest rates. The sudden possibility renewed worries about the collapsed housing market — where recovery may depend on rate cuts from the Fed — as well as other interest-sensitive sectors, and prompted the stocks of homebuilders and financial companies to dive.
Reports from retailers yesterday that sales posted another weak month in May after an abysmal April also renewed concerns about economic growth, hurting stores such as Wal-Mart, J.C. Penney and Macy’s, and sending their stocks plummeting.
“A week ago the main perception was that the Fed would leave its rates unchanged for the rest of the year. Now the perception is that the Fed may raise its rates sometimes this year,” said Hugh Johnson, an analyst at Illington Advisors.
Mr. Evans said some sectors will do better than others in an economy with low growth and rising prices.
“Pick stocks that can do well in an inflationary environment, such as consumer staples, technology and select financial companies, or high-quality mortgage companies whose profit margins depend on the yield spread,” he said.
Bill Gross, the influential manager of Pimco, the world’s largest bond fund, said he still expects the housing debacle to force the Fed to lower short-term rates later this year, but he has grown more pessimistic about future years, when he expects inflation and interest rates to climb. Treasury’s bellwether 10-year bond yield could rise as high as 6.5 percent, he said.
“After 25 years of being a bull market manager to all of a sudden become a bear market manager, although mildly so in terms of higher interest rates over the next three to five years, is sort of a major shift,” he said. “But I think it is a well-deserved shift.”
Some analysts said the reversion to more normal levels of interest rates may signal the unwinding of the unusually low rates that since 2003 stoked first the housing bubble, and later a boom in leveraged investments and buyouts on Wall Street.
Former Fed Chairman Alan Greenspan called the low rates a “conundrum” that was due partly to the gigantic multi-trillion dollar reserves of Asian countries that were invested mostly in U.S. bonds and were keeping rates low.
“The great conundrum that Chairman Greenspan spoke about many years ago, driven by global reserves recycling into U.S. Treasuries, is unwinding, leading to higher long yields and steeper curves,” said Brian Varga, a bond strategist at Countrywide Securities Corp. “Yields are competing for capital with equities and other riskier asset classes.”
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