In 1994, long-term interest rates skyrocketed. In 1995, they plummeted. Over the past six weeks, they have spiked again -- and, all the while, the inflation rate has stayed much the same.
There's a message here for investors in bond mutual funds: Sit tight.
The values of bond fund shares, which move inversely to interest rates, already are down as much as 8 percent.
In the short run, bond interest rates are unpredictable because they depend on psychology, and that's changeable.
But in the long run, they fundamentally reflect inflation -- and the expectations of greater inflation are still slim.
Interest rates could tick up a bit more, bond gurus say, but most believe that the bellwether 30-year U.S. Treasury bond, now yielding 6.6 percent, will drop back to 6 percent by year-end.
That's where it was in early February.
"If you're in a bond fund, this is not the time to get out," advises Paul Boltz, chief economist of Baltimore's T. Rowe Price.
"The sell-off has already occurred."
This is the third time in three years that the market has suffered unwarranted psychological seizures.
In 1994, collapsing prices pushed yields on 30-year bonds from 6 percent to 8.1 percent, the worst one-year sell-off in decades.
That was a big year for the economy, which grew an unusually crisp 3.5 percent, but the Federal Reserve continually increased short-term interest rates to keep inflation in check.
As it turned out, inflation in 1994 came in at 2.6 percent, down from 3 percent in 1993.
The bond market, conceding that inflationary fears were unfounded, rallied sharply in 1995, pushing yields back to where they were at the start of 1994.
Last year, inflation again remained essentially flat, at 2.8 percent.
The bond market stayed calm this year until mid-February, when rates began moving up again on diverging views about the strength of the economy.
In addition, Republican Sen. Bob Dole, the biggest champion of an inflation-fighting balanced budget, was having trouble in the early presidential primaries.
The clincher came March 8, when the government reported the creation of 705,000 jobs in February, a 13-year record.
Bond prices crumbled again, pushing up the yield on the 30-year bond a quarter of a percentage point in one day.
Once again, however, perception clouded reality.
Economists almost uniformly say that the jobs report was a fluke, for seasonal and technical reasons.
Growth will remain moderate and inflation will remain low, they say, and there's no shortage of indicators to support their view: Business inventories are high, layoffs are increasing and the consumer debt-to-income level is at a record 90 percent.
"The bond market tends to see what it wants want to see," says Art Micheletti, chief economist at Bailard, Biehl & Kaiser, which is urging investors to put 30 percent of their assets in bonds, the most since 1993.
"Right now, it's ignoring evidence of a weaker economy and positive inflation news."
Bond funds have a place in the portfolios of most investors, especially if they're at least 50 years old, because they offer stable interest payments and diversity. As volatile as bonds can be, they're usually less volatile than stocks.
But bond fund investors should develop a sense of when to stay put by learning to discern perception from reality. Experts suggest keeping an eye on three factors.
For starters, pay attention to the inflation rate. If it remains modest, as it is these days, bonds are safe, notwithstanding a contrarian economic indicator or two.
Also look at what the Federal Reserve is doing. If it's trimming rates, that's an affirmation that the Fed isn't worried about inflation, making bonds especially appealing. The Fed has cut rates three times since last July, and experts say it seldom changes course quickly.
Lastly, bond investors should view sharp bond rate fluctuations in context. If they occur relatively often, as they recently have, they mean much less than an isolated event.
"We've been here before," says Gary Conway, president of Sand Hill Advisors in Menlo Park, Calif. "That tells me this is nothing out of the norm and so nothing to worry about."
Most encouraging, most analysts expect inflation to remain tame as far as they can see. Some, like Mr. Conway, believe it will fall substantially more, which would sharply increase bond fund returns.
They cite various reasons: The dollar, which has been weak for years, is finally showing signs of strength, suggesting import prices will be lower; consumers are resisting sudden rises in prices; the Federal Reserve hasn't been this consistently committed to fighting inflation in decades; and the nation's 76 million baby boomers, the youngest of whom are 32, are focusing more on saving and less on spending money to rear young families.
"Don't let the day-to-day fluctuations in the bond market bother you," advises Frazier Evans, chief economist of Boston-based Colonial mutual funds. "Remember, it's an assembly of human beings, and human beings are emotional."
Pub Date: 3/31/96