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How the Bond Markets React
A New Weekly Fixed Income Feature at the BlueCollarDollar

03.24.05

Bear

Alan Greenspan and company raised rates for the seventh and certainly not the last time on Tuesday. The reaction to the expected quarter point increase was far from muted as the language that came from the meeting expressed concern over the possibility of inflation.

The Fed's "change in risk assessment" statement started a selloff in Treasuries that pushed yields well over the 4.6% mark. Expect that number to go higher as fixed income investors dump their long term positions in a search for a safe haven. Unfortunately, that won't be easy to find.

Bill Gross of PIMCO suggested that the best thing that could happen to this market would be the removal of the Asian purchasing of Treasuries. These foreign banks have kept the prices, which move in the opposite direction of yields, artificially high and this has had a negative effect on the inflation protected notes. If the Asians were out of the picture, Mr. Gross believes that the Fed could do what it needs to do in terms of raising short term interest rates as needed perhaps even more aggressively.

Hardest hit was the closed end bond funds, whose strategy of investing borrowed money became more difficult with each increase in short term rates. When rates go up, and they are expected to continue upward in the near future, these funds, whose pricing of net asset value is not fixed at the end of the day like open end funds but rather trades like shares throughout, will be hurt the most.

Because they use a leveraged (borrowed) position to increase income, these funds will find it more difficult to maneuver in a high interest rate environment.

It is widely assumed, and some of this assumption may be already priced into the market, that the Fed will raise the rate as much as 50 basis points at their next meeting six weeks from now. Each time a report is issued showing a growth in inflation, the Fed will react. Unfortunately, the bond market will react in a bearish manner as well.