The Fed: The Bond Market's New Hedge Fund?

The bond market got a big shock in March when the Federal Reserve announced plans to buy $300 billion of Treasuries. Rates on long-term bonds, which had been rising, dropped 17% in a single day as prices soared. Traders who bet against Treasuries took a nasty hit while managers who owned them got a quick boost.

Investors don't know how to deal with this new and massive force in the bond market. "The Fed's like a hedge fund at a poker game," says Jason R. Graybill, a senior managing director at Carret Asset Management.

For years the central bank has kept a tight grip on short-term interest rates by adjusting the rates at which banks lend to each other. Long-term rates, though, typically fluctuate based on investor perception about the U.S. economy. But now the central bank is meddling with long-term rates by purchasing Treasuries and mortgage bonds as part of a broader effort to revive the economy. As rates inch up, there's speculation on Wall Street that the Fed may purchase $1 trillion more in Treasuries to keep rates in check.

But the Fed either doesn't have—or doesn't want—the same all-powerful sway with long-term rates that it has with short-term ones. At most, says Brian Brennan, manager of T. Rowe Price U.S. Treasury (TROW) funds, the central bank can only slow long-term rates, much "like putting an umbrella under a waterfall." Meanwhile, the debt purchases are amping up market volatility and leaving bond investors scrambling. The Fed is keeping "the marketplace off balance," says George L. Ball, chairman of independent brokerage Sanders Morris Harris Group.

It's been a tough lesson for the market. When the Fed said in March that it wanted to keep rates low by buying bonds, many investors took the words at face value. For weeks the Fed purchased bonds every time rates approached 3%. Investors assumed the Fed had drawn a line in the sand to keep bonds below that—and they dutifully stepped in to buy at the same time.

They were wrong. On Apr. 29 the interest rates on 10-year bonds blew past 3%. Why? The U.S. flooded the market with new Treasuries, depressing prices and boosting rates. Compounding matters, better-than-expected economic news prompted investors to dump U.S. bonds in favor of riskier assets. All that set off a chain reaction: Traders rushed to sell bonds and inflation hawks bet against them, which sent rates skyrocketing to nearly 4%. They currently hover around 3.7%. "People had too much confidence in the Fed," says Don Galante, senior vice-president for fixed income at MF Global (MF), a broker.

Traders and managers are adjusting to this new uncertainty. Some are avoiding U.S. bonds and buying corporate bonds, where prices are based largely on underlying fundamentals. Others are trying to capitalize on the Fed's moves. Carret's Graybill, for example, is doing the opposite of the government: He's buying when Treasury is selling, since the additional supply tends to depress prices. "Our clients aren't enthused by the volatility," says Max E. Bublitz, chief strategist for money manager SCM Advisors. "But it's an unbelievable opportunity."

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