Waking up to price pressure
The bond market was shrugging off inflation fears. Not anymore
Call it irrational complacency. For months, as the Federal Reserve Board hiked short-term interest rates, bond investors paid scant notice and continued to shovel money into long-term treasuries, which pushed bond prices up and yields down. Between June 30, 2004, when the Fed started inching up rates, and Feb. 9, 2005, yields on 10-year treasury notes sank from 4.62 percent to 3.98 percent. As Fed Chairman Alan Greenspan pointed out recently, that's not the way the bond market is supposed to work. He described this disconnect as a "conundrum."
What gives? "The majority of the market was looking at a scenario where they assumed inflation was going to stay low for some time," says Mario DeRose, fixed-income strategist for the brokerage Edward Jones. But all of a sudden those same "what--me worry?" bond investors are all atwitter about some key signs of inflation. The turnabout caused a major sell-off in the past couple of weeks, driving 10-year treasury yields back up as high as 4.54 percent in what has been an unusually volatile period for the normally staid fixed-income market. Indeed, long-term government bond funds lost 1.7 percent on average over the past month, as rising interest rates lowered the value of bond portfolios. Because long-term treasury rates influence the mortgage market, the average 30-year fixed-rate mortage has also moved higher, from 5.57 percent in February to nearly 6 percent last week.
Thank Greenspan for sparking the newfound fears. His "conundrum" remark may have scared the markets straight by implying that long-term bond yields should have been higher all along and hinting--in his own cryptic way--that inflation, while tame, still needs to be monitored vigilantly. "Greenspan, with his influence, gave legitimacy to the view that interest rates were unsustainably low," says Richard DeKaser, chief economist with National City Corp.
Now, Wall Street is thinking that "the Fed might want to move a little more aggressively on the interest-rate front if inflation picks up," says Anthony Chan, a senior economist with J. P. Morgan Fleming Asset Management. While everyone expects the Fed to raise short-term rates another quarter of a percentage point when it meets this week, the big question is how the Fed will characterize its interest-rate policy.
Of course, it's not just the Fed. The recent volatility in the energy markets also spooked bond investors. After appearing as if they would stabilize, crude oil futures contract prices soared to a record high of more than $57 a barrel last week. That began to fan fears that rising energy costs will eventually boost the price of manufactured goods. Despite this, inflation hasn't really taken hold, as the consumer price index has risen 3 percent over the past 12 months. While that's higher than of late, it is still within the long-term historic rate of inflation.
But the bond market, which has enjoyed a two-decade-long bull run, is no longer interested in putting on its rose-colored glasses. One reason: Profit growth among large U.S. corporations is slowing significantly. After rising an estimated 20 percent in the fourth quarter of 2004, earnings of S&P 500 companies are expected to climb just 7.3 percent in the first quarter of 2005, according to Thomson Financial. With corporate profits already under pressure, Wall Street believes it will be difficult for businesses not to pass along higher costs to customers. If that happened, inflation would indeed pick up, and bonds, whose modest returns are wrecked by inflation, could be in for a rough patch.
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