It’s a long time since we had a bear market in bonds. Some may remember 1994, when Greenspan shocked the market from its complacency with a series of hikes in the Fed Funds rate. Events culminated that year with the bankruptcy of Orange County due to ill-advised bets on continued low rates by its treasurer Robert Citron. Or 1987, when a weak US$ and rising trade deficit led to rising bond yields and ultimately a stock market crash. The economy barely reacted to the turmoil on Wall Street and continued its expansion.

The problem today for bond investors is that, although the value in bonds is somewhat better with higher yields, they’re still not remotely cheap. The FOMC tells you on their website that the equilibrium Fed Funds rate is 4%. They don’t tell you when we’ll get to that level, but a clear consensus of FOMC members expects to begin raising the Fed Funds rate by 2015, two years from now. Even a measured pace of 0.25% per quarter would get short term rates to 4% by 2018. On that basis, a ten year treasury note yielding 2.4%, albeit 0.80% or so better for investors than a few months ago, doesn’t exactly represent compelling value. Personally, I think ten year notes would need to yield 4%, or 2% over inflation, before they’d even be worth considering. The same applies to corporate bonds adjusted up by an appropriate credit spread. The realization that the Fed will, in the foreseeable future, curtail their support of bond prices reveals how little true value they offer once the biggest buyer modifies its interest.

Based on what the FOMC discloses publicly about their rate forecasts – and their forecasts are more important than yours or mine since they can make them happen – I imagine Ben Bernanke must not think bonds represent a particularly good investment for anyone who’s a commercially driven investor. In other words, unless you’re a central bank looking to influence rates or park large reserves somewhere safe, don’t do what I’m doing.

In spite of the equity market’s poor reaction, it’s worth considering that the FOMC’s latest move (or signaled move, since they haven’t actually curtailed their $85 billion a month in purchases) may be well judged. So far since 2008 you’d have to give them credit for pursuing unconventional means boldly. Inflation remains low and economic growth remains positive although unemployment is still high. The Bernanke haters who own gold and gold-related investments on the dubious grounds that some greater fool exists to pay a higher price for a fairly useless, heavy, non-income generating mineral have done even worse than bond investors. As the Irish builder in Fawlty Towers sagely noted to Basil following a botched job, “There’s always someone worse off than yourself, Mr. Fawlty.” To which Fawlty replied, “Well I’d like to meet him then. I could do with a laugh.” So Mr. Bond Buyer, cast your gaze on the Gold Bugs and cheer up.

Bill Gross is by any measure financially sophisticated. Which is why it’s entertaining to watch him reconcile his undoubtedly well-honed skills at investing with his firm’s management of one of the most overpriced closed end funds around. The closed end fund sector is one of the truly inefficient sectors in financial markets. Investors routinely confuse distributions with yield, and presume that a security sporting a 10% yield is offering good value that has just been overlooked by many other investors.

So it is that the Pimco High Income Fund (PHK) recently reached a price of $14, a heady 70% premium to the NAV of its assets. It reached this level because investors are searching for yield everywhere, and because Bill Gross is the portfolio manager. For many investors, Bill Gross at any price is better than the tyranny of low market rates, and who can blame them.

Barron’s ran an article on the weekend noting the absurdly high premium to NAV of this fund. Mr. Gross does eats his own cooking by investing a modest amount of his net worth in the fund. He would know as well as anybody that investing in a portfolio of high yield bonds at 70% above their market value is not a sensible strategy, and yet as PM he can hardly advise that way nor sell his own shares. This week PHK has fallen spectacularly (at least, by the standards of closed end funds) falling around 20% from its level of last week. It still sports a heady 50% premium, and perhaps that will be sustained. It’s not possible to short it, but let’s just say there are quite a few more sensible places to put your money than PHK. Unless you’re the PM there’s not much point in owning it.

March 2022. That is the point at which, according to eurodollar futures prices, three month Libor will reach the heady yield of 4%. Ten years from now until money market yields are restored to “equilibrium” as defined by the FOMC in their rate forecast issued for their January 24-25 meeting earlier this year (reproduced below). The time to reach equilibrium is not defined in their forecast, so plausibly their forecast could be consistent with market interest rates. But I suspect that if asked whether it’ll take ten years for conditions to return to normal, Ben Bernanke would sound somewhat more optimistic than that. Or put another way, if during one of his testimonies before Congress he suggested that we have another ten years of digging to get out of the economic hole we dug in ’07-’08, many Congressmen might take the view that this is far too long.

So the bond market disagrees with this outlook. Bond investors believe we are ten years away from full recovery, while the government believes or hopes that this is far too pessimistic. Forecasts can differ, but meanwhile I keep returning to the fascinating optics of the Federal Reserve imposing on the market (through Operation Twist and its predecessors) long term interest rates that reflect market forecasts they themselves find too pessimistic. The only way to reconcile the Fed’s actions with its forecast is to acknowledge that its bond purchases are uneconomic – indeed, they are intended to be so. As the logic goes, maintaining stimulative interest rate policies is the best way to assure that ultimate recovery and an improved labor market both transpire.

It’s rare that a central bank provides so much information about its thinking. An easy way to square the circle would be for the FOMC to produce rate forecasts that are consistent with the yields at which they’re buying bonds. It would ensure consistency between their actions and their forecasts, but to their credit the Fed is promoting far greater transparency than they did under Greenspan. Consequently, presuming that the FOMC doesn’t seriously believe it’ll be ten years before a return to equilibrium interest rates, they are investing at yields too low for any commercially driven bond buyer. This is not even a guess; the Fed is telling you so! The Fed doesn’t need to make profitable investments, and they likely expect to hold what they own until maturity. But if you could catch Bernanke at an unguarded moment, perhaps over a glass of wine with no press nearby, he would surely acknowledge this incongruity and justify it based on the Fed’s twin mandate of promoting full employment consistent with stable inflation. The Fed is doing what they’re supposed to. And they are explaining it as plainly as anyone could hope.  Today’s bond buyer needs to be a very definitely not-hold-to-maturity type to make a profitable investment in ten year treasuries at 2.3% (or corporate bonds tethered through credit spreads to this return-free yield). If it turns out badly because the Fed starts raising rates with a view to reaching their longer run objective before 2022, it’s because the investor didn’t become a trader quickly enough.

Jeffrey Lacker, President of the Richmond Fed, thinks rates may need to rise as soon as next year. He is presumably one of the dots in the chart reproduced below, and no doubt one of the more hawkish. How fascinating to be able to ask him what he thinks of current interest rates. In fact, he’s already told you.

Eurodollar futures provide quite precise data about the market consensus forecast for interest rates. Since they extend out for ten years, they provide a rich set of information constantly updated about where market participants think 3 month Libor will be every three months.

The FOMC recently started making public the interest rate forecasts of its members. They issued a graphical representation of when FOMC members expect to begin tightening and what each member expects the year-end rate to be through 2014. You can find it here listed as “Projection Materials” for their press conference. For some weeks now I’ve felt that there exists a mild discrepancy between the rate forecasts imbedded in the eurodollar futures curve and the FOMC’s forecasts. For instance, only 6 of 17 FOMC members expect the Fed to begin tightening by 2013, whereas 11 (i.e. a majority) expect so by 2014. So the majority think they’ll be raising rates no later than 2014. Similarly, the median rate forecast of FOMC members at the end of 2013 is 0.25%, but a year later it’s 0.75%. Moreover, if you compare the average forecast rather than the median, rates are expected to move from 0.56% to 1.12% (there are a couple of outliers on the high side). So on balance, it looks as if the FOMC expects short term rates to rise around 0.5% during 2014.

Meanwhile, the spread between the September 2013 and September 2014 eurodollar futures yields is 0.36%. The market is priced for less of a tightening than the FOMC is forecasting.

Now eurodollar futures and the yield curve in general are analyzed probably more closely by more smart people than any other variable in financial markets. In addition, not all FOMC members vote, and it’s not clear what each members’ forecast is (although you can make some reasonable assumptions based on public comments by individual members). Current market pricing is not an oversight, it correctly reflects market expectations. And yet, were you able to sit in on a discussion of the FOMC, or better yet debate interest rate forecasts with them, they would likely tell you that the yield curve out to three years is not pricing in enough of a tightening of short term rates. Of course, the FOMC’s forecast could be wrong; after all, they really don’t know more than anyone else about what the economy will be doing in 2014. One interpretation of market pricing is precisely this – FOMC members are overly optimistic about GDP growth and the economy will still be facing headwinds 2-3 years out.

This may be so, and yet the knowledge that the FOMC thinks the yield curve is too flat would have been considered valuable inside information not so very long ago. Today, it’s public information. And they are of course in a position to make their forecasts come true.

The view that the yield curve is too flat can be most easily expressed through a long eurodollar futures calendar spread (long September 2013 and short September 2014), betting on a wider spread or steeper yield curve between those two points. Not everyone chooses to trade futures, but the rate forecasts revealed explicitly in the eurodollar futures curve are part of the term structure of bonds as well. Although the eurodollar futures market makes plain the precise path of interest rates the market expects, bond yields of different maturities are priced to be largely consistent with the same information. So an investor today who selects five year bonds over shorter maturity two years in exchange for the modest yield pick-up available is effectively rejecting the FOMC’s interest rate forecast as too optimistic on the economy. The FOMC is telling you they think you’re making a mistake.

Disclosure: Author is Long the September 2013/2014 eurodollar calendar spread.