By Richard Leong and Ellen Freilich

NEW YORK, Feb 3 (Reuters) - A rough couple of months in the

U.S. bond market has lifted interest rates off record lows and

now could impede a slow economic recovery heavily dependent on

cheap money to keep going.

While stocks have surged to near-record levels from five

years ago, an accompanying rally in the $11.6 trillion U.S.

Treasury debt market appears to have run out of steam and bond

prices have dropped steadily since early December. That has

pushed up bond yields, which move in the opposite direction to

prices and they are now at the highest levels since last spring.

Some of what's behind the sell-off can be seen as positive -

greater investor confidence in riskier assets such as stocks,

signs the European debt crisis is abating and a spate of U.S.

economic indicators that point to more growth.

As bonds fall out of favor, however, credit-sensitive

corners of the economy could start to feel the pinch. The

housing market, car sales and business and public sector

investment will be vulnerable as the cost of borrowing rises

because all credit costs are ultimately tied to the Treasury

market.

'I do fall into the camp of people who worry what will

happen when rates go up,' said Tom Nelson, chief investment

officer at New York-based Reich & Tang, a firm with nearly half

of its $28 billion in assets under supervision in money market

mutual funds.

Of course, the demise of the three-decade bond-market rally

has been forecast repeatedly in recent years. Just last March,

Bill Gross, manager of the world's largest bond fund, the PIMCO

Total Return fund, sharply cut his exposure to U.S. Treasuries.

Bonds proceeded to rally through November, driving the yield on

the benchmark 10-year Treasury note to well below 2 percent.

The threat of a major sell-off remains distant in many

investors' minds because the market enjoys one big source of

demand - the U.S. Federal Reserve. As part of its latest effort

to prop up the economy by flooding the banking system with cash,

the Fed has been buying $85 billion of Treasuries and mortgage

bonds from banks each month since September and has no plans to

ease up anytime soon.

RISING RATES

Still, investors have grown more hungry for higher yields,

driving investment fund flows into equities and away from bonds

in the past couple of months. The Standard & Poor's 500 index

has delivered a total return in excess of 6 percent since the

end of November, while the return on Treasuries has been a

negative 1.3 percent, according to Bank of America/Merrill Lynch

Fixed Income Index data.

As a result, the 10-year yield last week rose to more than 2

percent for the first time in nine months. Expectations are for

yields to move higher, at least modestly.

'This is the biggest risk for bond investors,' Hans

Mikkelsen, a bond strategist with Bank of America Merrill Lynch

in New York. 'I'm surprised we have gotten to 2 percent

already.'

In October, Mikkelsen forecast a 'Great Rotation' from bonds

into stocks in early 2013. Also, a survey last week by J.P.

Morgan showed that one in four investors own fewer Treasuries

than their portfolio benchmarks, the most in almost 19 months.

And ultimately, analysts agree the Fed's highly

accommodative monetary policy must come to an end.

Nelson from Reich & Tang recalled 1994, when the Fed raised

its benchmark federal funds rate six times, to 5.50 percent from

3 percent.

'When the Fed starts to raise rates, they're not going to go

to 35 basis points,' Nelson said. 'There's a high probability

that they will move faster than they did in 1994 because just

getting back to neutral will mean a sharp rise in rates.'

BANANA PEEL FOR HOUSING?

The spike in Treasury yields, from which most U.S. mortgage

interest rates are derived, comes at a sensitive moment for a

housing market that has just started gaining traction. Rising

mortgage costs could slow investments in real estate, which

contributed to economic growth in 2012 for the first time since

the housing bubble burst five years ago.

The average interest rate on 30-year mortgages, the most

widely held type of U.S. home loan, has increased by 0.15

percentage point to 3.67 percent, according to the Mortgage

Bankers Association. That rate would probably have to rise to

about 4 percent to hurt housing by discouraging investors from

pouring more cash into the sector, analysts said.

Rapidly rising yields would also squeeze businesses and

local governments looking to borrow to spend on building plants

and roads or hire workers. Like mortgage rates, public and

private borrowing costs are linked to Treasury yields.

Berkshire Hathaway Inc, run by billionaire investor

Warren Buffett, sold $2.6 billion of debt last week. The timing

was seen as a response to a recent rise in U.S. Treasury rates

and Buffett has a reputation for spotting turning points.

DEJA VU ALL OVER AGAIN

Still, the bond market has seen this before. In the last two

years, bond yields rose in the first quarter, only to fade by

spring as growth slowed and Europe's debt crisis flared up.

'Each year we've had waves of optimism and pessimism. Right

now, investors are on the optimistic foot,' said Robert Tipp,

chief investment strategist at Prudential Fixed Income in

Newark, New Jersey.

Even if yields rise modestly, it is not bad for everyone.

Banks would see profit margins improve as their short-term

borrowing costs will likely remain near zero because the Fed is

expected to stick to ultra loose monetary policy into 2015.

For savers who have seen their incomes dwindle, a pickup in

interest on bank accounts and money mutual funds should be a

relief and perhaps encourage them to spend a bit more.

Overall, economists do not think the ingredients are in

place for more than a modest rise in rates in 2013. The economic

growth trend is still spotty. Even an aggressive forecast would

still not bet on Fed raising rates until somewhere in 2014.

'It's not the final bell for the bond market just yet,

though it's getting closer,' said Daniel Heckman, senior fixed

income strategist at U.S. Bank Wealth Management in Minneapolis.

(Reporting by Richard Leong and Ellen Freilich; Editing by

David Gaffen and Andre Grenon)

Keywords: USA BONDS/OUTLOOK

(richard.leong@thomsonreuters.com)(+1 646 303 6313)(Reuters Messaging: richard.leong.thomsonreuters.com@thomsonreuters.net)(Twitter @RichardLeong2)

COPYRIGHT

Copyright Thomson Reuters 2013. All rights reserved.

The copying, republication or redistribution of Reuters News Content, including by framing or similar means, is expressly prohibited without the prior written consent of Thomson Reuters.