Fed moves give recently battered bonds a boost

Stock brokers are a familiar breed to many investors. Bond traders remain a mystery to most.

Yet bonds represent a large, important financial market. When a bubble in bond prices burst in late June, causing hundreds of billions of dollars of losses to investors, economists wondered if the economic recovery would be hurt.

"Not a huge impact," says Cynthia Latta, an economist with Global Insight, a consulting firm in Lexington, Mass.

Nonetheless, last Tuesday Federal Reserve policymakers thought it wise to calm bond-market fears. In a communiqué announcing no change in a key short-term interest rate, the Federal Open Market Committee stated that "on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future." And it added that "policy accommodation [that is, low interest rates] can be maintained for a considerable period."

Such an explicit call on interest rates for, presumably, many months ahead is unusual, if not unprecedented.

"That was significant," says Daniel Fuss, portfolio manager of the $1.77 billion Loomis Sayles Bond Fund. "I expect to see a billboard on top of the Fed building next time I'm in Washington: 'Keeping rates down.' "

Wall Street now assumes the Fed won't hike short-term interest rates, at least not until there are clear signs the economic recovery is chugging along at a healthy, sustainable pace.

Mr. Fuss suspects the Fed won't raise rates until after the 2004 election.

The first President Bush blamed the Fed and its chairman, Alan Greenspan, for a lackadaisical economic recovery in the early 1990s. He figured it cost him reelection. Mr. Greenspan, a Republican, may want to avoid doing similar damage to George W. Bush.

The Fed can manage the short-term federal funds rate, the interest banks charge on overnight loans. It kept the rate at 1 percent last week, the lowest level since the 1950s. Long-term rates are a different matter.

"The average investor has maybe an overestimation of the control the Fed has over long-term interest rates," says Bradley Sweeney, a bond analyst at Morningstar Inc., a Chicago research firm.

The day after the Fed's meeting, the Commerce Department announced that July retail sales surged 1.4 percent, exceeding expectations.

That was taken as a sign that the recovery was picking up steam, as forecast. So the day the Fed would start raising rates to deter inflation is closer.

Immediately the yield on medium- and long-term bonds rose in the bond market, and thus their prices fell. Ten-year Treasury bonds jumped to 4.567 percent, a 12-month high, just above the rate after the Fed's June meeting. The 10-year rate largely governs mortgage rates, so vital to home buyers.

Back in late June, many traders had hoped for a half-percentage-point reduction in the Fed rate. They got a quarter.

Also, in July testimony to Congress, Greenspan hinted that the Fed was unlikely to use "unconventional" means to tackle deflation. Some bond people thought they had been misled by the Fed, that earlier Greenspan remarks suggested the Fed might, say, buy 10-year Treasuries to make sure the economy had enough liquidity to stop prices from falling.

"The Fed appeared to back off," notes Ben Herzon, a senior economist with Macroeconomic Advisers in St. Louis.

He's forecasting a real 4.2 percent growth rate for the remainder of the year, 4 percent next year. That's enough to start gradually shrinking the jobless rate.

Shocked bond traders began throwing criticisms at Greenspan.

"After the 2000 break in the equity [stock] market and after the bond-market bubble broke, the perception of Greenspan has changed from being able to do no wrong to being able to do no right," says Michael Cosgrove, an economist at the University of Dallas management school in Irving, Texas.

The Fed, says Fuss, is "in a tough, tough spot."

Some bond portfolios were hit hard. There are some $2.7 trillion of nonfinancial corporate bonds, $3.6 billion of Treasuries, $1.4 trillion of municipal bonds, and $2.8 trillion bonds of government-sponsored agencies, such as those that package bundles of mortgages into bond securities.

A one-point jump in the long-term interest rate results in almost a 10 percent drop in the price of long-term bonds. Some hedge funds, borrowing money to leverage long-term bond investments, were probably especially hard hit.

July was the worst month since December 1981 for the Lehman Brothers Aggregate Bond Index. The shares of some 335 intermediate-term bond funds lost an average 4.3 percent in value, funds invested in long-term government bonds lost 10.4 percent, calculates Morningstar. Fearing further losses, some investors have been taking money out of bond funds.

But Fuss, of Loomis Sayles, says, "I like this kind of market. We are in a transition market ... from declining interest rates to rising interest rates."

Last month's extraordinary surge in bond rates, he figures, covers about half of the total interest-rate rise he expects for this recovery period. Three or four years from now, the 10-year Treasury rate will be about 5.25 percent, the 30-year Treasury rate 6.25 percent, he predicts.

"It's not the end of the world for the bond market," Fuss says. His top- performing fund has given investors a 14 percent return this year to the end of July.