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[TTHQ Staff]

BEING STREET SMART ____________________ Sy Harding The Puzzling Bond Market! February 4, 2005. Looking back over the years bonds have certainly belied their reputation for being dull. During the 1990s even U.S. Treasury bonds, the safest of bonds, went through several cycles that saw rallies of as much as 24% and plunges of as much as 18%. More recently, over the last three years treasury bonds have gone through several more double-digit rallies and subsequent double-digit declines. The main key to bond prices is usually the direction of interest rates. For instance, the big decline in bond prices in 1998 and 1999 was influenced by expectations that the Federal Reserve would begin to raise interest rates to cool off the then over-heated economy. And the Fed did take that action, with a string of six rate hikes beginning the following year. But the Fed slowed the economy too much, and it was headed into what became the 2001 recession. So bonds rallied strongly in 2000 and 2001 in anticipation that the Fed would have to begin cutting interest rates aggressively to re-stimulate the economy. And the Fed did that, with a string of 13 rate cuts beginning in January of 2001. But for the last nine months bonds have been acting counter to what would normally be expected of them. The Federal Reserve began raising interest rates last June to ward off inflation, and with this week’s further hike, has now raised short-term rates six times since last June. Normally that would have had bonds plunging. Yet the price of bonds only flattened out for awhile, and more recently have rallied again. It has bond experts scratching their heads. Most began warning last June of the high risk in bonds going forward. At the time Steve Leuthold, esteemed chairman of the Leuthold Group, and lead manager of the Leuthold Funds, said he wouldn’t touch bonds with a nine-foot pole. (More recently he updated that to say he wouldn’t touch bonds now with a nineteen-foot pole). One of the most successful fund managers, Garrett Thornburg of Thornburg Investment Management, oversees $12.6 billion in investor assets in his various funds. In an interview in a financial publication this week he is quoted as still expecting “a coming bond market crash”. Upon being reminded that while the Fed has raised short-term interest rates six times since last June, longer term rates have actually declined some, Thornburg insisted long-term rates will have to follow short-term rates up (sending bond prices down). “They always have, every time.” Thornburg said. Bill Gross is probably the most successful bond investor of his generation, often referred to as the Warren Buffett of bonds. He is one of the founders of PIMCO, which manages $400 billion worldwide, mostly for institutions. Gross manages the firm’s bond fund, which is the world’s largest with $40 billion in assets. He has been warning about the risk in bonds for close to a year now. Both Thornburg and Gross provide the same explanation of why, while many large players are bailing out of bonds (Thornburg has his bond fund 35% in cash), bonds prices are holding up. They say it’s thanks to “the kindness of strangers”. They explain that as the willingness of foreign central banks, especially those of China and Japan, to continue buying U.S. bonds. Last year China and Japan purchased roughly 30% of all the new Treasury securities the U.S. issued to finance its record budget and trade deficits. China and Japan continue buying dollar denominated assets even though they lose money on them due to the declining value of the dollar, because the trade-off is that by continuing to finance the growing American debt they keep their exports flowing to the U.S. and their own economies more healthy. However, Thornburg, Gross, and others, expect that kindness has reached its limit and will soon come to an end, allowing rising interest rates and rising inflation to have their normal negative effect on bonds. Meanwhile, bond market observers continue to scratch their heads. Bonds rallied again on Friday, in reaction to the report that employment growth wasn’t quite as strong in January as economists had expected. That apparently raised hope in the bond market that the economy is not as strong as it has appeared to be, and the Federal Reserve will not dare to continue raising interest rates. But the stock market seemed to think otherwise and also rallied strongly, apparently of the opinion that the economy is just as robust as the Federal Reserve claims it is. Sy Harding is president of Asset Management Research Corp., DeLand, FL, publisher of The Street Smart Report Online at www.streetsmartreport.com and author of 1999’s Riding The Bear – How To Prosper In the Coming Bear Market.