Bonds: Plan for more of the unexpected

Prices remain firm despite economic trends.
NEW YORK (AP) -- The bond market wasn't supposed to finish out the year this way. With the dollar slumping, the U.S. economy improving and the Federal Reserve taking action to keep growth in check, the good times were supposed to fizzle.
But that didn't happen. In fact, it turns out the yield on the 10-year Treasury note -- the benchmark for everything from mortgage rates to how much corporations have to pay to borrow money -- might close out 2004 lower than where it started.
Sure, that's higher than the near half-century lows that the yield dropped to more than a year and a half ago, but this market hasn't been performing over the last 12 months like anyone expected.
It's starting to sound a bit like a broken record when you talk about bonds. Over the last year or so, there have been forecasts predicting an imminent retreat leading to prices dropping and yields rising -- they move in opposite directions.
Switching course
And at points along the way, it has looked like the pullback was beginning. Then the market would switch course.
This seesawing has surprised many market watchers, who believed it was inevitable that yields would surge as more bearish factors loomed over the bond market.
To start, the Fed has shifted into a tightening mode for short-term interest rates, boosting its target for the federal funds rate -- the rates banks charge each other on overnight loans -- by a quarter percentage point five times since June. It now stands at 2.25 percent.
The Fed's move comes as the U.S. economy appears to be picking up steam. The gross domestic product expanded at a faster-than-expected annual rate of 4 percent in the third quarter, the Commerce Department reported last Wednesday.
The weak dollar also creates potential problems by lowering demand for dollar-denominated securities. That was confirmed by a recent report from the U.S. Treasury that showed foreign purchases of U.S. assets are waning.
In addition, the declining dollar can boost inflation -- something that is usually troubling to bond buyers.
But none of that seems to have had much effect on bonds. The 10-year Treasury note peaked at 4.87 percent in June, but hasn't come close to such heights in months. And while it is up more than one percentage point from its 45-year lows reached in June 2003, it is only trading around 4.3 percent -- not high by any standard.
How it played in 1994
That isn't how things played out in 1994 when the Fed began a sustained series of rate increases. The bond market reacted by sending yields on the 10-year note rising from 5.75 percent to 8 percent in just a few months, said Standard & amp; Poor's chief economist David Wyss.
Back then, the Fed surprised the market when it started boosting interest rates and bond buyers were keeping close tabs on any signs of inflation after the sharp run-up seen in the 1980s.
This time around, Fed Chairman Alan Greenspan and his team have gone out of their way to make it known that the tightening cycle would continue. And while inflation is rising, it's growth is still considered tame.
Lehman Brothers U.S. economist Ethan Harris, in a recent note to clients, tried to make some sense of why there hasn't been a reversal in the bond market. "In our view, the underlying fundamentals for bonds are on net worsening even as the market rallies," he said.
Maybe it's that investors believe the economy isn't on a fast track, which could explain why there is such a disconnect between the improving economic data and the lack of movement in long-term rates. But Harris questions that theory because other financial markets aren't following a similar path.
Maybe it's that investors see the Fed's rate increases as the right step in containing inflationary pressures. But as Harris points out, consumer prices are drifting higher, and "we have never seen an inflation acceleration that the bond market liked."
Not behaving as it should
Maybe it's that investors are confident foreigners -- particularly Asian central banks -- will continue to pour big money into the Treasury market. Yet Harris notes that the bond market isn't behaving as it should if it was so focused on the positives of central bank intervention. Under those circumstances, the bond market would have its strongest days when the dollar fell, but there is little correlation between the two right now.
So it seems that even the experts can't pin down a good reason why the bond market is behaving like it is, and that long-term interest rates seem to be settling into a spot where no one expected them to be.
It may just take one bit of news to throw this market the other way. That could happen should there be more evidence of rising inflation or new data pointing to stronger-than-expected employment growth.
"There is a lot of wishful thinking going on in the marketplace, but that could cause trouble if those expectations turn out to be wrong," said Sung Won Sohn, chief economist at Wells Fargo & amp; Co. in Minneapolis.
Still, that doesn't seem to be worrying many investors -- right now at least. Hopefully, that won't cost them later.

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