Bond yields risk for stocks: BofA

By Ros Krasny

NEW YORK (Reuters) - Equity investors can't ignore the recent sharp rise in yields for U.S. Treasury debt, which has the potential to tamp down gains in stock prices, Banc of America Securities' chief investment strategist said on Monday.

"We see higher bond yields as a risk," Banc of America's Tom McManus said at the Reuters Investment Summit in New York. "We still see decelerating earnings as a risk."

McManus said price pressure was still lurking in the U.S. economy despite the recent decline in some inflation indicators. "We don't believe inflationary expectations will be coming down. We think they will continue to rise."

Policy-makers will keep a close eye on rising prices for agricultural and industrial commodities, as well as U.S. labor costs, even as core inflation measures fall, he said.

"There is a good chance that if inflation expectations come up just a little bit the Fed may decide to go to 5.5 percent and start the whole process anew."

The U.S. Federal Reserve has kept its overnight lending at 5.25 percent since June 2006.

McManus said higher bond yields will necessitate a higher return on all financial assets to keep pace, as well as hurting the liquidity available for potential deals.

"People have been scrambling to get deals done before the window closes," he said, adding that the upward yield trek will also tend to raise the level of risk aversion in financial markets.

The benchmark 10-year U.S. Treasury note yield hit 5.25 percent on Friday, the highest level since mid-2006.

Investors have driven up yields recently on concerns that inflation will stay higher than desired by the Federal Reserve, stamping out any chance the Fed will cut rates for the foreseeable future.

McManus said higher yields stand to hurt consumer spending as adjustable rate mortgages of yesteryear are refinanced at higher interest rates.

Even apart from the highly publicized subprime loans, many prime mortgages taken out as three-year ARMs will be resetting this year and "could easily adjust (upward) by 200 basis points," McManus said.

That will create "a little bit of sticker shock" for homeowners and squeeze spending on discretionary items, he said.

The discretionary consumer spending sector "has been a good one to be underweight in," he said.

McManus said he currently favors large-cap stocks in the consumer staples and health-care sectors, as well as certain industrial companies with exposure to the growing global economy.

(For summit blog: summitnotebook.reuters.com/)