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.

As Bill Gross, manager of the $76 billion

(PTTAX) - Get Report

Pimco Total Return fund said on

CNBC

after the announcement, if anyone was looking for signs that the Fed might pause, "it's not in there."

If the Fed continues to steadily tighten monetary policy in the coming year, the dislocations that were feared but avoided in 2004 might emerge after all.

Carrying On the Carry Trade

Indeed, hedge funds still are pouring money into so-called carry trades, borrowing in dollars to invest in assets abroad, be they emerging market bonds, commodities or other currencies. On a recent visit to London, Morgan Stanley analyst Andy Xie said he encountered hordes of hedge funds putting back on carry trades they had unwound earlier in the year. With borrowing rates in the U.S. below the rate of inflation, fund managers figure they can't lose by borrowing at low short-term rates and reinvesting in higher-yielding assets -- at least until rates go higher.

"The low fed funds rate is the source of enthusiasm for carry trades," Xie wrote last week. "The amount of liquidity with money managers, especially in hedge funds, is still significant. Another 100 basis points

1% of rate hikes by the Fed could reverse this liquidity tide."

Following Wednesday's statement, most observers now expect that the Fed will engage in a relatively unusual December rate hike. Futures contracts linked to the fed funds rates for January have fallen from an implied yield of just over 2%, indicating no move at December's meeting, to 2.21% at the close on Wednesday, implying an almost certain move.

Looking farther out, fed funds contracts don't have enough volume to provide much guidance. Futures linked to the rate paid on eurodollar deposits have 10 times the trading interest but aren't a perfect analog. Still, they also signaled a shift in expectations as the December 2005 contract showed a yield of about 3.5% on Wednesday compared to 3.2% before Friday's report and close to 3% a few weeks earlier. The actual eurodollar interest rate is typically about 0.25% above the fed funds rate but an additional risk premium for future contracts muddies the waters. That said, the market is looking for at most 1% of additional tightening after the Fed presumably hikes the rate to 2.25% next month.

Looking at the bond market, Gross said the 10-year note yield reflects the expectation that the Fed will halt its rate-hike campaign even sooner, stopping with the fed funds rates at 2.5% or less.

In Gross' shop, they've been expecting that the Fed's tardiness in raising rates has set the stage for an upswing in inflation, the real destroyer of bond value. While Fed officials and other economists have played down the significance of sky-high oil prices, Pimco managers see crude's rise as a sign of just how much stimulation has been pumped into the economy.

"The reality has to acknowledge the fact that oil may be as much of a symptom as a cause of inflation," John Brynjolfsson, another Pimco fund manager, wrote this week.

The Fed's low rates have helped the markets weather the end of the Internet bubble, he wrote, "but it is that liquidity which fuels world aggregate demand to the point where oil demand is getting ahead of supply and the same dynamic affects other areas; healthcare, housing and the economy more generally."

The weak dollar also feeds inflation by raising the cost of imported goods. The dollar hit an all-time low vs. the euro this week and was near decade lows against other major currencies. A Commerce Department report on Wednesday found the price of imported goods had risen 12% over the past year and almost 3% excluding oil. And the Fed can address the dollar's weakness only by raising rates. Indeed, the dollar stiffened a bit against the euro on Wednesday after the hike.

So the Fed has but one way to go, and that could be a painful march for the complacent.

While the ramifications are most acute for fixed-income investors, a report by Prudential Equity Group found financial institutions such as

Citigroup

(C) - Get Report

,

Bank of America

(BAC) - Get Report

and

Fifth Third Bancorp

(FITB) - Get Report

have yet to rearrange their balance sheets in anticipation of higher rates. Homebuilders are also still loading up on debt to buy land in anticipation that real estate will stay hot, even as the refinancing boom wanes and still higher rates threaten to curtail future housing activity.

In keeping with TSC's editorial policy, Pressman doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send

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