No. of Recommendations: 6
"Wouldn't reasonably expected interest rate increases already be priced into bonds?"

The notion of "priced into the market," either stocks or bonds, is a tautology—what's priced in this minute is priced differently the next, with the upshot that the only practical implication of "the market is always right," a.k.a., "the market is always wrong," "efficient markets" theory being that on the average the higher costs (and taxes) generated from trying to beat the average will lead to losing to the average, which is why many of us stick to index funds.

Interest rates/bond prices are set by supply and demand. The Fed discount rate affects supply by making it cheaper or more expensive for banks to borrow from the government printing press for money they then loan out at a profit. This has a fairly direct affect on very short term bonds, with the affect being less as the maturities of bonds increase. In fact, what we have seen, as the Fed has increased the discount rate from 1% to 2.25% is a steady increase in short term T-bills. 5-year and 10-year T-bills have not gone up to the same degree.

What has kept bond prices, in general, and longer bonds in particular at lower rates has less to do with the supply side (Fed discount rate) and more to do with a continued demand for T-bills, despite the huge deficit in the US General Fund. The demand is principally coming from two places: the Social Security Trust Fund surplus, which is buying around 40% of the General Fund deficit (at sweetheart rates) and foreign governments (China, Japan) buying US T-bills with trade surplus $$$. There are signs the foreign buying has slowed, and we know the Social Security surplus will be peaking within a few years (the projected date for going into deficit is c. 2018, but the surplus will start declining before then, c. 2011, when the first boomers hit 65).

Traders, who only have a limited impact on the bond market anyway, since so much of the demand for T-bills comes from the Social Security and foreign governments, trade in anticipation of short term fluctuations. So far, they have not panicked into selling T-bills with the expectations of a sudden shift in foreign investment (e.g., the Chinese deciding to dump their T-bills en masse). But over time, the balance of supply and demand is highly suggestive that interest rates have to go up to cover the deficit in the US General Fund (the "cutting in half in 5-years" hype from the Bush administration, if they pulled it off, and their projections ignore such niceties as Iraq and fixing AMT and borrowing a couple hundred billion per year on margin for their private Social Security accounts, starts from a $800 plus billion deficit in the General Fund, based on an inflated projection they used to claim they were making deficit reductions, and includes continuing increases in Social Security Surplus, so they would really only be decreasing the real General Fund deficit from around $700 billion in 2004 to $600 billion in 2009).

At any rate, if and when these macro economic factors decrease the relative demand for T-bills, that will get priced into the market, either suddenly in anticipation of changes or gradually as the changes occur. If and when that happens, bonds bought at lower yields will be worth less.

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