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Fed on hold, but bond buyers beware
Central bank unlikely to raise rates soon; some analysts warning bonds may be too pricey.
March 12, 2004: 1:00 PM EST
By Mark Gongloff, CNN/Money staff writer

NEW YORK (CNN/Money) - Federal Reserve policy-makers are unlikely to move on monetary policy at their meeting next week, giving interest rates room to stay low and bond prices room to stay high.

But some analysts say Treasury bond investors ought to start gathering their coats -- the party may be over soon.

The central bank's policy-makers are scheduled to meet Tuesday to discuss the economy and their target for the federal funds rate, an overnight bank lending rate that influences many prime lending rates.

The Fed lowers its target when it wants to encourage borrowing and stimulate the economy. It raises the target when it wants to tap the economy's brakes and fend off inflation.

Few economists expect the Fed will change its target for the fed funds rate from 1 percent, the lowest level in more than 40 years.

Many economists also believe the Fed will leave unchanged the two-paragraph statement announcing its decision, which analysts scrutinize for clues about Fed expectations for economic growth, inflation and future policy moves.

"With few signs that consumer prices are about to break to the upside ... along with signs that aggregate demand remains robust, we expect the Fed will not only vote to keep rates constant, but will leave the growth and inflation bias statements unchanged," Lehman Brothers chief economist Ethan Harris wrote in a note to clients Friday.

The Fed busily slashed rates in 2001, fighting a recession and terror attacks, and added one cut a year in 2002 and 2003 when the economy was still not as robust as policy-makers had hoped.

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The super-low fed funds rate has helped keep longer-term rates low, assisted by the sluggish job market and low inflation, despite several quarters of strong economic growth.

Expectations that the job market would recover, and inflation would start to pick up, sent investors running into stocks last fall and winter, hurting bond prices. Since bond prices and yields move in opposite directions, the yield on the 10-year Treasury note jumped to about 4.6 percent in September.

Since then, however, the Labor Department has released several reports of weaker-than-expected job growth, and consumer price inflation has been dead in the water, despite a weakening dollar and higher commodity prices.

Friday morning, the yield on the 10-year Treasury note was back down to about 3.71 percent, matching its level a year ago when investors were snapping up bonds ahead of the U.S.-led war with Iraq.

Investors love Treasury bonds as a safe place to park their money, especially in times of uncertainty, but signs of economic strength will send them fleeing since inflation erodes the value of the investments.

Meanwhile, economists now say the Fed won't start raising rates until after the November election, with some saying it won't until next year, meaning a jump in longer-term rates could be delayed for quite some time.

"Even with significant employment gains, the central bank wants to see more inflation and pricing power. The fall election is another hurdle," said Sung Won Sohn, chief economist at Wells Fargo. " No hike in the interest rate is likely in 2004."

Until last week's much weaker-than-expected jobs report, some analysts thought the central bank would start raising short-term rates this summer.

Time to get out of bonds?

Still, there's no reason for bond traders to get complacent, analysts say. The first report of solid job growth -- whenever that will be -- could send Treasury bonds tumbling, pushing long-term rates higher, even if the Fed doesn't move on short-term rates right away.

And if you happen to believe in buying low and selling high, this is not exactly an ideal time to buy bonds. With yields not much above the record lows set in mid-2003, how much lower can they go?

"If one buys bonds now, one has to expect the possibility of a capital loss over the next six months," said former Fed Governor Lyle Gramley, now a consulting economist with Schwab Washington Research. "I don't worry about prices collapsing or spiking up, but 3.75 percent is an historically low [10-year note yield]."

What's more, the consensus forecast for a prolonged period of low inflation and low rates has some factors working against it:

  • The dollar continues to fall, putting upward pressure on inflation and interest rates
  • Big federal budget deficits mean the government has to borrow more, increasing the supply of bonds, which hurts prices and tends to push bond market interest rates higher
  • Prices for commodities, imports and many consumer services are rising -- all of which could translate into gains in consumer price inflation

"This is the way inflation gains a toe hold," Robert Brusca, chief economist at Fact and Opinion Economics in New York, said on Thursday. "The chance to buy bonds is past us," he added. "It is now time to sell them ... if you haven't already."

In the short run, however, bond prices could be kept afloat by a number of traders engaging in strategies such as the "carry trade," or borrowing money at cheap short-term rates and then buying longer-term bonds that yield more.

As long as the Fed keeps the overnight rate super-low, the carry trade and strategies like it are safe and should keep demand for bonds relatively high.

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What's more, foreign central banks have pumped billions of dollars into the bond market in a bid to keep the dollar strong against their own currencies.

Analysts have prematurely declared the end of the bond rally several times in recent years, but it won't keep going forever.

"For a trader, there are still [short-term] opportunities, but if I were a longer-term investor, I would not want to be holding bonds," said Joseph Shatz, fixed-income strategist at Merrill Lynch.  Top of page

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