WASHINGTON -- The wreckage in the bond market from rising interest rates is a good case in point of how even the smart guys can get burned.
The comfortable predictions and assumptions that financial analysts used to set their portfolio strategies for 1994 have gone wrong, and it has cost Wall Street traders and investors a bundle. In the process, small investors have trustingly held on to their stocks and bonds while they dropped in price.
The way the international bond mavens had it figured, this year's calls on interest rates and the dollar were a cinch.
In the U.S., short-term interest rates were supposed to rise modestly as the Federal Reserve tightened policy, and long-term rates were supposed to go up even less. A group of 30 economists surveyed by The Bond Buyer last December forecast that at the end of June three-month Treasury bills would be yielding 3.37% and the 30-year bond would yield 6.32%. Last week, three-month bills reached 4%, and the long bond was at 7.50%.
The average fixed-rate mortgage rate hit 8.5% last week, the highest level in early two years.
Overseas, analysts were confident that sluggish economies and easy money policies by the central banks in Europe and Japan would keep pushing rates down. It hasn't happened that way. While the central banks have kept short-term rates slack, long-term rates have gone up in Japan, France, Germany, and the United Kingdom.
In Germany, for example, one-month bill rates fell to 5.25% from 6% in January, but the yield on 10-year bonds jumped to 6.6% from 5.50%.
The combination of rising rates in the U.S. and falling rates in Europe was supposed to make dollar-denominated assets more attractive and push up the dollar in foreign exchange markets. Instead, the dollar eroded steadily, forcing last week's U.S.-led intervention by the central banks, and global bond yields are up.
The situation has been fueled by the huge flows of borrowed money that grease the wheels of finance Banks stepped up their loans to brokerage firms, which in turn provided credit to customers through accounts on margin.
That is not unusual. But this time around the hedge funds, private groups of investors who place bets that are highly leveraged, have been big players in the market. And there has been widespread use of derivatives, the sophisticated products that are linked to prices of securities or some kind of financial index. The banks and brokerage houses found eager customers for these products both as investments and to hedge against risk.
Unfortunately, says Thomas Synnott, chief economist for U.S. Trust Co., in New York, many of the derivatives had hedging formulas that worked only when changes in bond prices were small. When the bond market rumbled, the holders of these products got left holding the bag.
"What makes this episode in the bond market different is the extensive use of derivatives," Synnott writes in the latest issue of Standard & Poor's Credit Week. "Once bond prices began to fall, the combination of leverage and elaborate hedges, which did not work as intended, amplified the initial decline."
Not everyone took a hit, however. Bankers Trust New York Corp. reported a tidy $114 million first-quarter profit from the sale of derivatives to clients. It was the buyers of these products -- blue-chip names like Procter & Gamble Co., Gibson Greetings Inc., and Dell Computer Corp. -- that lost on the bets they placed with their bankers.
On Wall Street, there's always a seller for every buyer.