ANALYSIS-Specter of higher rates menaces Wall Street

NEW YORK, June 8 - Wall Street, they say, is constantly climbing a wall of worry. Rising bond yields are making that wall a lot steeper.

Investors have anxiously anticipated a correction after a 40 percent run-up in shares, but so far, it has not materialized.

If there is one emerging factor that could change that, it is the rise in bond yields, which complicates the Federal Reserve's efforts to resuscitate the economy.

Hopes that the recession may be moderating have helped fuel a stock market rebound from 12-year lows of early March, but the rally has run into headwinds, causing the benchmark S&P 500 to stall out after gaining nearly 40 percent between early March and early May.

Analysts say stocks could succumb to more volatility in the days ahead as investors reassess the allure of U.S. paper assets and whether they have the stomach for more risk.

"In general, the equity market and anybody tied to the economy really wants to see interest rates lower to stimulate growth," said Owen Fitzpatrick, head of Deutsche Bank Private Wealth Management's U.S. equity group in New York. "High interest rates tend to choke any signs of growth."

The rise in yields has been dramatic: The U.S. 10-year Treasury note's yield climbed to 3.91 percent on Monday, a seven-month high, compared with the end of March, when the yield was just 2.67 percent.

Rising rates boost borrowing costs for both businesses and consumers, making prospects for a revival in profit growth that more challenging.

WHEN YIELDS JUMP, EQUITIES SUFFER

A rapid increase in interest rates is particularly detrimental to equities. According to Bank of America-Merrill Lynch, sharp jumps in 10-year note yields, similar to the move in the last two months, have resulted in below-average returns in subsequent periods for equities.

Since 1979, the average three-month gain for large-cap stocks has been 2.8 percent. But after periods with similar increases in rates, the average gain has been just 1.2 percent. Small-cap stocks perform even worse, gaining 0.7 percent, compared with average three-month gains of 2.9 percent.

For that reason, Bank of America/Merrill analysts say investors might want to be cautious.

"Defense is the best offense," they said, advising clients to be particularly careful of small-cap stocks as they were historically more vulnerable to rate increases.

"Moving up the market-cap spectrum, we also see below- average performance by the mid-caps and the large-caps when rates rise dramatically."

Sectors likely to take a hit from a prohibitive rise in the cost of capital include cyclical and consumer-oriented plays such as retail, housing and technology, as well as industrials.

But rising long-term rates help other sectors of the economy fare better, particularly the banking sector as a steeper yield curve is helpful to bank profitability.

Research by Bank of America/Merrill Lynch shows that sectors that tend to outperform in the wake of rate rises were utilities, financials, and consumer staples.

Utilities came in at the top spot over the subsequent three-month time frame at a 2.4 percent rate of return, and fell to third place for the full year at 6.0 percent.

Financial services were second best over the subsequent three months and full year, while consumer staples flip-flopped with utilities, ranking third after three months, and first after a year.

The other standout is healthcare, with a full-year excess return of 4.7 percent, according to BofA/Merrill.

The specter of rising interest rates could not have come at a worse time for the stock market, particularly as the dollar's course remains insecure, and economic data, while improved, remains shaky.

"This economy is still very fragile, and it takes a long time for a recovery, especially with a recession of this magnitude," said Don Galante, senior vice president of fixed income at MF Global in New York. "So I think this market is a little ahead of itself."