What Really Rattled The Bond Market Wasn't Inflation

Ever since the Federal Reserve hiked short-term interest rates on Feb. 4 and the bond markets in the U.S. and abroad violently plunged, the financial markets have been seized by inflation fears. But they're spooked by the wrong demon: The worry now shouldn't be a reprise of inflation past but powerful downward pressure on prices.

Clearly, the economic fundamentals don't explain the bond-market carnage. In the bloodied markets of Japan and Europe, growth is anemic and inflation negligible--and likely will stay that way. As for the resurgent U.S. economy, the major price indexes suggest inflation is running well below 2%. True, some industries are increasing prices, and a bowl of Special K costs more than a year ago. "But there's a big difference between one-shot increases in prices and an ongoing inflation," says James Tobin, an economist at Yale University and a Nobel laureate.

BURST BUBBLE. Indeed, in today's tightly connected, quicksilver capital markets, had inflation pressures driven investors to dump bonds, both their computer models and market tradition almost certainly would have siphoned money off into that classic inflation hedge--gold. Yet since the Fed tightened, gold-mining share prices have dropped by 11% and gold prices by 3%; the price of oil--"black gold"--is down by more than 8%.

No, the precipitous fall in bond prices has little to do with inflation--and everything to do with the sudden bursting of a huge speculative bubble in the global fixed-income markets. And financial history shows that whenever a boom ends, the reversal always strikes with the unexpected brutality of a powerful earthquake.

In the past several years, financial gunslingers, including hedge fund operators, earned lottery-size profits the old-fashioned way: They rode a powerful bond bull market driven by continual disinflation--and amplified their investment returns with leverage.

One popular strategy of these investors involved buying U.S. government bonds maturing in two years (yielding, say, 4%) or in five years (yielding perhaps 5%) and funding those assets with money borrowed at the overnight rate (3% or so). With short-term rates staying low, investors traded confidently in long-term bonds, pocketing the spread between interest earned and the cost of carry.

Traders improved that return by sometimes leveraging up as high as 100 to 1, says John Taylor, president of F/X Concepts, a firm specializing in managing currency and interest rates. In addition, as the specter of disinflation and slow growth seized Japan and Europe, the gunslingers added leveraged bets on falling rates abroad to their portfolios. Many also took to aggressively speculating on currency swings.

It wasn't just the hedge funds and other fast-moving money managers that played the global fixed-income markets, though. The bull market in bonds and growing confidence in low interest rates, attracted more and more large investors, from managed futures pools to mutual funds to pension funds. The growing crowd spun the web of global leverage wider and wider. Others simply loaded up on long-term bonds, luxuriating in double-digit annual returns.

But when the Fed raised short rates, "the cost of carry increased, and things started to come unglued," says Eric Miller, chief investment officer at Donaldson, Lufkin & Jenrette Inc. The quarter-point hike surely wasn't dramatic, but leveraged speculators around the world panicked, bailing out to meet margin calls. No one wanted to buy their fixed-income securities, so liquidity dried up, yields spiked higher, and billions were lost. In a time-honored rhythm, financial success bred excess.

SPOOKED. By most reckonings, volatile trading conditions will continue for some time. Investors are too spooked and their losses too big. And in every major market, there are other factors contributing to the rise in rates. The Japanese bond market is skittish over a tsunami of new bonds to pay for the government's planned fiscal stimulus. In Germany, it's a higher-than-expected increase in the money supply. Still, as economic fundamentals reassert themselves, interest rates should be trending lower.

Yet the danger exists that the inflation fear haunting the Fed and the markets could send U.S. rates even higher. The markets sold off when the Fed raised short rates, believing the governors must know something about inflation that they didn't. Yet the Fed is relying much more on the market for its inflation signals. "Each is reacting to what it thinks the other believes and knows," worries David Resler, chief economist at Nomura Securities International Inc.

The big risk: Each side misreads the other, sending rates ever higher. Instead of combating inflation, high rates may actually slow growth, sending the global economy into a cycle of falling prices and lackluster demand. That deflationary scenario, certainly, is not what Fed Chairman Alan Greenspan intended.