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. ...