“Nearly everyone agrees the bond market will take a hit when the Federal Reserve starts raising short-term interest rates, perhaps as early as next month,” writes Aaron Lucchetti in today’s Wall Street Journal.

“But knowing that the Fed is going to move has hardly settled bond investors. Some worry the next few months will look like a repeat of the bloody bond market of 1994, when a relentless Fed rate-hike campaign sent bond prices sharply lower and triggered massive losses for pension funds and trading firms. Investors also are concerned about digesting large amounts of government debt stemming from rising deficits. This week, the government will sell $54 billion in Treasurys as part of a quarterly refunding.”

“Unlike in 1994, however, bond markets have started moving well ahead of the Fed. While policy makers have mildly tweaked their language concerning interest-rate policy, bond prices have taken a beating. Since late March, for example, the yields on both the two-year Treasury note and the five-year Treasury note have jumped by more than one percentage point. Since yields move inversely to a bond or note’s price, some Treasury investors have lost 10% or more.”

“By contrast, in 1994 the yields on the two shorter-term Treasurys rose only by about 0.2 percentage point, in the three months before the Fed’s first move. ‘The bond market was totally surprised in 1994,’ says Stan Jonas, managing director at Fimat USA in New York. This time around, bond traders have ‘priced in a good possibility’ of a 1994-type environment, he says.”

“The recent decline in bond prices means that bond investors who have been defensive, or kept money in very short-term instruments, have performed better than their peers. But Mr. Jonas says that defensive strategy may not be the best course today. ‘At the moment, I wouldn’t be short,’ he says, adding that there are ‘some very cheap’ choices now in the bond market.”

“Indeed, all types of corporate bonds, government agency bonds and foreign bonds, especially in emerging markets, have sold off even more sharply than Treasurys in recent days, a worrying sign for those who predicted the corporate bond market would digest interest-rate hikes with few problems.”

“As is always the case in the bond market, a lot is riding on the next batch of economic numbers, including inflation data expected Thursday and Friday. If inflation continues to rise and the economy continues to add jobs at a rapid pace, the bond market may tumble further.”

“Bond bears point out that once the economy starts to gather steam, it usually keeps its momentum until the Fed steps in to interrupt the party with rate hikes. They note that the Fed isn’t always successful at first in cooling things down.”

“But one reason bond prices may stabilize a bit is that the Fed has promised to go slow in raising rates to a more normal level. Today, the Fed’s short-term target rate, at which banks lend money to each other overnight, stands at a 46-year low of 1%.”

” ‘It’s always helpful to review, but I don’t think we’re looking at a 1994-type pattern,’ says Jack Malvey, chief global fixed-income strategist at Lehman Brothers. The Fed this time has said it ‘will be gradual’ in hiking rates, ‘and while there are signs that the inflation fuse has been lit, it’s not like the early 1990s,’ because productivity gains and overcapacity in the economy have pushed inflation so low.”