Investors back from the brink, but not far

Investors have basked for months in a powerful stock and corporate credit market rally, but the glow may fade as unprecedented measures to kick-start flagging economies mean near-zero inflation and benchmark interest rates won't last forever.

A surge in bond yields in the United States and elsewhere portends a sustained period of higher interest rates, boosting the cost of capital for corporate and consumer America.

Rising U.S. Treasury yields, with the yield on the 10-year note this week nearing 4.0 percent, have driven mortgage rates back up. That has threatened to kill a refinancing boom that has helped preserve the still-fragile health of recession-weary households and the banks that lend to them, at a time when credit losses show no sign of leveling off and the nation's unemployment rate races toward double-digits.

The rise in bond yields and mortgage rates may also act to check the huge recent rally in global stock markets of the past three months, with the Federal Reserve trying to end an 18-month recession and yet not spur inflation.

"What mistake can the U.S. economy afford to make? If you look at it that way, I suspect that we will see the Fed engage again in these markets," Mohamed El-Erian, chief executive of bond giant Pacific Investment Management Co., told Reuters Financial Television on Friday.

Between June 15 and June 18, fifteen leading analysts, economists and strategists including Goldman Sachs & Co's Abby Joseph Cohen, Citigroup's Tobias Levkovich, and Nouriel Roubini, a New York University professor who predicted much of the financial crisis, will discuss where the global economy goes from here at the annual Reuters Investment Outlook Summit in New York.

They are expected to discuss the surge in long-term Treasury yields that has commanded the attention of perhaps the most important U.S. economist of all, Fed Chairman Ben Bernanke. He has worried that the increase reflects "concerns about large federal deficits but also other causes."

BALANCE SHEET BLOAT

Debate is brewing within the Fed over whether to ramp up purchases of Treasuries, agency bonds and mortgage-backed securities, after the Fed began buying much of the debt in March.

Fed liquidity programs begun last year have doubled the size of its balance sheet to around $2 trillion, as the central bank flooded money into the economy to address the worst banking crisis since the Great Depression and the worst economic recession in more than a generation.

The Fed's efforts have succeeded in stabilizing a banking system that appeared set to collapse last September as credit markets seized up.

That month, the largest U.S. mortgage financiers, Fannie Mae (FNM.P: Quote, Profile, Research, Stock Buzz) and Freddie Mac (FRE.P: Quote, Profile, Research, Stock Buzz), became wards of the state, Lehman Brothers Holdings Inc (LEHMQ.PK: Quote, Profile, Research, Stock Buzz) went bankrupt, Washington Mutual Inc (WAMUQ.PK: Quote, Profile, Research, Stock Buzz) failed, Merrill Lynch & Co was bought by Bank of America Corp (BAC.N: Quote, Profile, Research, Stock Buzz), and the insurer American International Group Inc (AIG.N: Quote, Profile, Research, Stock Buzz) had to be rescued. Soon after, more than 600 banks took federal bailout funds.

Now, though, close to three dozen banks have gotten the green light to pay back some of their bailout funds. On Tuesday, regulators authorized 10 big banks to repay $68 billion, led by JPMorgan Chase & Co (JPM.N: Quote, Profile, Research, Stock Buzz) with $25 billion.

"That banks are repaying capital suggests more than mere stability, but actual balance sheet health and an ability to withstand another shock," said Timothy Ghriskey, chief investment officer of Solaris Asset Management in Bedford Hills, New York.

NOT DONE

Jamie Dimon, JPMorgan's chief executive, has praised the Fed for having "acted extremely well and thoughtfully," but said it must tread carefully to remove quantitative easing.

"If that is not done exactly right you will have higher inflation on the other side," he said on May 27.

Indeed, leaders of the world's fastest-growing major economy are wringing their hands over the Fed balance sheet.

China is threatening to reduce its buying of U.S. Treasury debt if the U.S. dollar slides further, and has suggested that Special Drawing Rights of the International Monetary Fund replace the greenback as the world's main reserve currency.

A United Nations panel has seconded China's motion, but just in case it doesn't happen, China is buying gold.

The Fed knows it has much to do.

"We are out of the end zone .... still marching down the field," Dallas Fed President Richard Fisher said on June 9, using an American football metaphor. "We have a ways to go."