Bond investors on edge as Fed prepares to raise interest rates

For bond investors who are convinced a lack of inflation will keep the US Federal Reserve from upending Treasuries when it begins to raise interest rates, there is one parallel in history that suggests they still have cause for concern.

The last time consumer-price increases were slowing before the Fed started increasing borrowing costs was in 1994 - when Treasuries lost 3.3 per cent in what was then the biggest sell-off on record. The Fed chairman at the time, Alan Greenspan, shocked the financial world by doubling the benchmark rate to 6 per cent, even though inflation was at a seven-year low of 2.5 per cent.

While there is less inflation now and growth still has not recovered to pre-crisis levels after six years of unprecedented stimulus, the risk is that bond bulls vindicated by this year's rally are misreading the Fed's resolve to lift rates from close to zero. Speculators pulled a record amount of money from long-term Treasuries after Fed chairman Janet Yellen said the bank's pledge to keep rates low for a "considerable time" may change if the economy picks up more than it expects.

"The critical example for the markets is 1994, and that's the thing that we all fear," said Gary Pollack, the New York-based head of fixed-income trading at Deutsche Bank's private wealth management unit.

This year, US government bonds have returned 3.5 per cent, according to a Bank of America Merrill Lynch index.

The gains have confounded prognosticators who foresaw declines as the United States economy strengthened and the central bank wound down its bond-buying programme. Yields on the 10-year note, the benchmark for trillions of dollars of debt, have fallen about a half-percentage point to 2.53 per cent.