“This was supposed to be the year to get out of bonds. Move back into the stock market or make a defensive bet on cash and take advantage of rising short-term interest rates, many pros recommended,” writes Aaron Lucchetti in today’s Wall Street Journal.

“So far, those suggestions have been dead wrong.”

“The benchmark 10-year Treasury note has returned 3.1% this year, far exceeding the performance of money-market funds and major stock-market averages, which have lost ground. After a powerful bond rally in the past two weeks, the yield on the 10-year note, which moves in the opposite direction of its price, has dropped to 4.25% from 4.60%. It now stands at about the same level as at the end of 2003 and well off the 4.87% level seen in June.”

“The latest bond rally gained steam on Friday when a far-weaker-than-expected July employment report sent investors running for cover to the haven of fixed-income investments such as bonds. Yesterday, the 10-year note gave back some of those gains, dropping 11/32 to 103 30/32, or $3.44 per $1,000 note.”

“Where does the bond market go from here? Today, the next clue comes from the Federal Reserve, which is widely expected to raise its target short-term interest rate by a quarter percentage point to 1.5% at its scheduled meeting. But traders and economists will look closely at the statement accompanying today’s Fed announcement for signals about whether the central bank is wavering on its plan to raise its target for the benchmark federal-funds rate, which banks charge each other for overnight loans, at future meetings.”

” ‘I think there’s a serious possibility the Fed will sit on its hands’ at its September meeting, says David Goldman, head of fixed-income research at Banc of America Securities. Mr. Goldman previously had predicted Fed rate increases in September and through the end of the year. But after the recent weakness in some economic indicators — including the jobs number — Mr. Goldman now says the Fed may skip the September increase if conditions don’t improve.”

“Indeed, after Friday’s report that the U.S. economy added only 32,000 jobs in July, the chance of a quarter-percentage-point short-term rate increase in September decreased to about 60% from 85% in the days before the jobs report, according to trading in fed-funds futures contracts.”

“Bond investors were caught off guard by the sudden weakness in job growth. Early last week, before the employment number came out, a J.P. Morgan survey found nearly four investors were bearish on bonds for every one who was bullish. ‘We were all surprised by the Friday number,’ Mr. Goldman says.”

“Bond investors are now dealing with a volatile mix of a suddenly tumultuous jobs picture, resurgent terrorism fears and a weak stock market. In addition, stubbornly high oil prices have helped stoke inflation fears, something that could force the Fed’s hand even if the economy remains fragile. Many of these factors have helped push up bond prices, making the once-conventional wisdom that this year could resemble the 1994 bear market in bonds seem premature, or flat out wrong. The 10-year Treasury lost more than 7% of its value in that difficult year, compared with the gains of 2004.”

“Those predicting higher yields believe they will be right. Eventually. ‘We still think we’ll see a 5% yield’ on the 10-year note, ‘but we keep pushing the date out,’ says Jack Malvey, chief global fixed-income strategist at Lehman Brothers. Mr. Malvey’s latest projection: bond yields will bounce around for a couple of months and then head up to 5% by early 2005.”

“All eyes today will be on the Fed’s statement. In its last statement, the Fed noted recent improvement in the job market. In this statement, some traders say the Fed may signal that it needs to see more data before it continues to push rates up.”