The Fed is twisting like John Travolta and Uma Thurman in "Pulp Fiction" in 1994. But will bond yields also head higher like they did in 1994 once Operation Twist is over?
NEW YORK (CNNMoney) -- 1994 was great for movie fans. "Pulp Fiction." "The Shawshank Redemption." "Forrest Gump." But bond investors definitely would rather forget that year.
The yield on the 30-year Treasury (then the benchmark, as opposed to the 10-year that's the benchmark now) began 1994 at about 5.8%. At the time, the economy was starting to show some signs of life after a big housing bust wreaked havoc on consumers and big banks. (Sound familiar?)
By the end of the year, long-term yields had popped to around 8%, one of the biggest bond market bloodbaths ever. Remember that prices fall when rates rise.
Flash forward to 2012. The 10-year started the year at a rate of just 1.87%. It spiked as high as 2.4% and has since settled back to about 2.25%. With the economy slowly improving, do bond investors have to fear that it's 1994 all over again?
Some experts are, to paraphrase the Ace of Base song that topped the charts in 1994, seeing the sign. (1994 was not nearly as good a year for music as it was for film.)
But rates may only go so high. The big difference between now and two decades ago is that, in 1994, the Federal Reserve under Alan Greenspan was raising rates.
Current Fed chairman Ben Bernanke has gone out of his way numerous times, including in a speech Monday morning, to point out that the central bank needs to stick with "accommodative" monetary policy to keep the job market and economy humming.
The Fed has already pledged to keep short-term rates near zero through the end of 2014. And investors strongly believe that if there's any evidence that economic growth is starting to stall, Bernanke will likely agree to the Fed's third big bond buying program since the 2008 financial crisis.
This so-called quantitative easing, or QE3, could put a lid on how high bond rates can go, experts said. That's because the Fed would be viewed as a buyer of last resort for long-term Treasuries.
"This is completely different from 1994," said Michael Mata, manager of the ING Global Bond Fund () in Atlanta. "As long as Bernanke is Fed Chairman, the Fed will buy more Treasuries as it deems necessary."
Still, many bond investors are bracing for higher rates -- albeit not at 1994 levels. If the economy continues to pick up steam, the Fed will probably let its current stimulus effort, which sells short-term bonds and uses the proceeds to buy long-term Treasuries, expire in June as currently scheduled.
The end of this program, dubbed "Operation Twist," should lead to more selling of long-term bonds and higher rates.
Wilmer Stith, portfolio manager of the Wilmington Trust Broad Market Bond Fund () in Baltimore, said that yields on the 10-year could climb as high as 3% after the Fed ceases with Twist. For this reason, he said his fund is betting more on high-quality, investment-grade corporate bonds over Treasuries.
But Stith points out that higher rates are not necessarily a significant problem for the economy -- as long as they don't climb too quickly. And he believes a move from 1.8% to 3% for the 10-year would lead some bond investors to flock back to Treasuries, since they might think the bonds are now a good value.
"At the end of the day, a slow but recovering economy should augur higher yields," Stith said. "But a yield near 3% would be up nicely from the lows, and the net result could be some more buyers."
Another key difference between 1994 and now was that 1994 was also a bad year for stocks. The S&P 500 and Nasdaq fell while the Dow finished the year up just 2%. Investors back then were nervous about the impact of the Fed's rate hikes on both corporate profits and the broader economy.
This year, investors seem to be fleeing bonds to rush back into stocks. But this newfound love for riskier assets could itself make life more difficult for bond investors.
Tommy Huie, president and CIO of BMO Asset Management US in Chicago, points out that, until Treasury yields spike significantly higher, investors who want to take part in the market rally but still receive steady income streams might be better off with dividend-paying companies. Heck, even Apple (Fortune 500) has finally agreed to pay a dividend.,
"There are many more attractive opportunities than Treasuries," Huie said. "Concerns about another sell-off like 1994 are legitimate. But it will probably be gradual. Rates may creep up as opposed to spiking up."
Politics could affect bond yields too. Doug Peebles, head of fixed income for AllianceBernstein in New York, said he's being asked the 1994 question more often lately -- especially from people in Europe.
With the U.S. facing yet another crucial deadline for the debt ceiling sometime after the presidential election, it's possible that bond rates could move much higher (like they did in Italy, Spain and yes, Greece) if investors feel that Republicans and Democrats can't come to a meaningful agreement on deficit reduction.
Peebles said he does think Treasury rates should be higher than what they are now, but that it's highly unlikely yields will approach the levels well north of 5% that plague Spain and Italy.
Of course, how high rates head all depends on the economy. And at least one investing expert is worried that if the Fed continues to stick with its pledge to leave short-term rates low for another two years, even if the recovery proves to be sustainable, inflation fears could resurface with a vengeance.
"The slump in economic activity won't last forever. Interest rates near their lows won't last forever," said Keith Skeoch, CEO of Standard Life Investments in Edinburgh, Scotland. "Something strange is afoot. The bond sell-off is going to happen. It's just a matter of when."
Best of StockTwits: Some traders are starting to wonder if Bernanke has "I heart QE" tattooed on his bicep.
This is what worries most about the rally this year. It's hard to tell whether investors really think the economy is getting better, or if they are willing to keep buying stocks because they think Bernanke will drop another quarter in the QE pinball machine every time the market flashes Tilt.
EddyElfenbein: Always amazed at the disconnect between what Ben Bernanke says and what some people think he says.
A fair point. Bernanke isn't completely tipping his hand. While he's not as opaque as his predecessor Mr. Greenspan, he's not as blunt as his European contemporary Mario Draghi at the ECB.
Investors may be grasping for QE3 straws in every Bernanke utterance. But after QE1, QE2 and Operation Twist, can you blame them?
The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, and Abbott Laboratories, La Monica does not own positions in any individual stocks.
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