Ghosts of 1994: Gone but Not Exorcised

For much of the spring and summer, the question on every bond investor's mind was whether 2004 would be a reprise of 1994. In that annus horribilis for fixed income, the Federal Reserve raised rates more than most expected, putting a sudden and painful end to all manner of carry trades and leveraged bets.

Despite expectations the Fed will follow Wednesday's 25-basis point rate hike with another in December, it's fair to say the answer is that 2004 was certainly not 1994. The yield on the 10-year Treasury note, which rises when its price falls, opens at 4.25% Thursday morning, well above its low of 3.96% last month but a shade below where it started the year. The average government bond fund has gained 5.27% so far this year, according to Morningstar, while junk and emerging market bond funds have done even better, returning about 8% on average.

Now comes the sequel: Will 2005 be the new 1994? With months of complacency among fixed-income investors seemingly vindicated, the answer could be yes. Either a strong economy or a surge in inflation will prompt the Fed to drive rates higher than the market expects.

Complacency was certainly the watchword Wednesday. Well before the 2:15 p.m. EST announcement, virtually every analyst, trader and money manager had fully priced in the 25 basis-point point hike adopted by the Federal Open Market Committee. Any previous doubters had been convinced when the Labor Department announced on Friday that the U.S. economy added 337,000 jobs in October, about double what economists had predicted.

The Fed made only a few changes to its outlook statement from the one issued in September. The economy is growing at a "moderate pace" the Fed said Wednesday, instead of just having "regained some traction" back in September. The labor market has "improved" instead of just "improved modestly." And inflation is "contained" instead of having "eased." The central bank retained all its language suggesting that it expected to raise rates at a "measured" pace dependent on changes in economic prospects.