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Watch Your Step When You’re Watching The Fed Tweak Rates Moves By Central Bank Often Have Unexpected Results

Whatever information you use as an investor in bond mutual funds, be very careful about basing your decisions on the actions of the Federal Reserve.

As the past year has demonstrated, the Fed’s moves to tighten or ease credit conditions often have surprising results for bond prices and interest rates - and for the returns achieved by funds that invest in bonds.

Last March, the Fed raised a pivotal short-term interest rate known as the federal funds rate by a quarter of a percentage point, to 5.5 percent, in a dose of preventative medicine against inflation. Long-term interest rates in the bond market already were moving up amid fears that inflationary pressures might be increasing.

If you reasoned that tighter money was bad for bonds - higher interest rates, after all, mean lower bond prices - you might have pulled out of a bond fund, or at least shied away from investing any new money.

But in fact, at that point the bond market and bond funds were about to embark on a rally that paid a nice return to investors. Indexes of long-term bond funds calculated by Lipper Analytical Services Inc. wound up the year with total returns of between 9 percent and 13 percent.

Traders in the bond market collectively came to the conclusion that inflation was going to decline, not increase, especially with the Fed having signaled its readiness to act against upward wage and price pressures.

The investment management firm of Trevor Stewart Burton & Jacobsen said it began to lengthen the duration of its bond portfolio soon after the federal funds rate increase. “We think that people came to realize that inflation would not come back despite a strong economy, and in fact would continue to go down,” said Alan Kral, bond portfolio manager at the firm.

Duration is a measure of the sensitivity of a portfolio of bonds to interest-rate changes. “As interest rates have fallen, portfolios with longer durations, which are more responsive to interest-rate fluctuations, have generally fared better than their shorter-duration brethren,” notes the Value Line Mutual Fund Survey.

Now, in early 1998, the big worry on many people’s minds is not inflation but deflation, or the possibility (however slight) of a painful contracting process spreading outward from the Asian financial crisis.

The most widely recognized measure of inflation, the consumer price index, rose just 1.7 percent in 1997 for its second-smallest increase in the past 30 years. So the conjecture is that the Fed’s next move might be to nudge short-term interest rates lower, easing credit conditions.

The lower inflation goes, the better bond traders like it. Outright deflation is a great environment for top-quality bonds such as those issued by the U.S. Treasury, as long as there is little or no perceived threat that the issuer won’t be able to pay its interest and principal obligations.

After all, when you buy a Treasury bond you are making a loan. And if prices fall, each dollar you have lent out gains additional purchasing power, enhancing its value to you once you get it back.

Should the Fed lower short-term rates sometime soon, attesting to expectations among the central bank’s policy-makers of continued low inflation or even deflation, government bond traders might greet the news with an initial show of enthusiasm.

But at least some investors would read a stimulative measure by the Fed as a possible source of rekindled inflationary pressures, or at least of increased inflation worries in the bond market. At the very least, visions of Treasury bonds thriving on deflation could very well fade.

So should you dump your bond funds if the Fed eases credit? Hard to tell.

No matter which way monetary policy is moving, Fed-watching has been demonstrated to be a difficult guessing game.

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