Commentary > Bid and Ask
Once bitten...
Burned by the Fed in 1994, the bond market is playing it cautious.
August 12, 2003: 9:00 AM EDT
By Justin Lahart, CNN/Money Senior Writer

NEW YORK (CNN/Money) - The bond market is convinced that it's 1994 all over again. The Fed's job on Tuesday is to try to convince investors that this is not the case.

1994 was a disastrous year for bonds, with many investors caught unawares of how aggressively the Fed would tighten the screws as it engineered a "soft landing" for the too-hot U.S. economy. After holding steady at 3 percent for over a year, the Fed, between February 1994 and January 1995, ran the fed funds target rate up to 6 percent.

The Treasury market got slaughtered. The yield on the 10-year note went from an October 1993 low of 5.19 percent up to a November 1994 peak of 8.05 percent. The rout left many investors badly damaged and some, like the hedge fund Askin Capital Management, were forced to shut their doors. The experience left a deep scar on the market. Participants vowed not to let it happen again.

So this time around they began unloading Treasurys much earlier in the game, and much faster. Between Oct. 15, 1993 and the Fed's Feb. 4, 1994 tightening, the yield on the 10-year went up just three-quarters of a percentage point. In contrast, from its June 13 low of 3.11 percent, the 10-year's yield has already traveled more than 1.25 percentage points.

Yet nobody, not even the economy's biggest bulls, thinks the Fed is going to be raising rates this year, and some economists believe it will be on hold until 2005.

How come? Think back on 1994. When the Fed began hiking, the recession had been over for three full years. If it followed the same script this time around, it wouldn't raise rates until fall of next year. Back in 1994, the unemployment rate had been falling for over a year and it was down more than a full percentage point from its peak. Given the slack that exists in the economy now, the employment picture isn't likely to begin improving until the end of 2003.

But bond investors would rather play it safe than take their chances. That's unfortunate, because the backup in rates is dragging down the U.S. economy, leaving it vulnerable to shock.  Top of page

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