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Dow Jones Newswires recently ran a survey of the Treasury bond market's 21 primary dealers. These are the bond dealers "that trade directly with the Federal Reserve and underwrite Treasury debt sales." So reported The Wall Street Journal on Monday, December 17.

The forecast? At the end of 2013, the median 10-year yield will be around 2.25 percent. This is up from a yield of about 1.71 percent at the close of business on Friday. On Monday, the 10-year closed around 1.77 percent.

So the median forecast is for the 10-year Treasury bond yield to rise about 50 basis points.

Note, there were three of the dealers that expected interest rates to be lower at the end of next year than they are now.

The highest expected yield: a forecast of 3.00 percent.

The general feeling is that the government budget problems now gathering so many headlines will be resolved.

I believe that longer-term interest rates will be higher at the end of next year, and I put myself in the group that expects these rates to increase to a level above the median rate forecast by the dealers.

I believe that the major factor impacting the level of longer-term interest rates at the end of next year will be the situation in Europe. If the Europeans are seen to be further on the road toward achieving a unification of their banking system, and if they are also moving along on the road to a fiscal union, then the longer-term interest rates in the United States will rise.

I believe that the United States is still benefiting from "flight to quality" caused by the financial upheaval that the European Union has been going through. This "flight to quality" has been so substantial that the Treasury's inflation adjusted securities have been trading at a negative yield.

On Monday, December 17, the 10-year inflation adjusted Treasury yield was around a negative 0.82 percent.

The 10-year inflation adjusted Treasury of constant maturity first dropped below zero at the start of November 2010. It bounced back above zero for a short time but then dropped below again, where it has remained. The fall in this yield below zero was tied relatively closely to the financial problems that were being experienced in Europe.

Note that the yield on the 10-year Treasury bond was about 2.00 percent so that the difference in yields between the regular 10-year Treasury bond and the 10-year inflation adjusted bond was about 200 basis points. Over the past two years, the difference between the two fluctuated first around this 200 basis point level, but then began to increase in September 2012 to around 250 basis points.

When did the differential begin to grow? Well, right after the Federal Reserve System started to pitch the third round of quantitative easing. The basis point differential between the 10-year regular bond and the 10-year TIPS has been interpreted as the market's estimate of inflationary expectations. So one could interpret the rise in the interest rate spread in the fall of 2012 as an increase in the market's expectations of future inflation, from 2.00 percent to 2.50 percent.

The point I am getting at, however, is that the TIPS yield plunged below zero as the flight of funds from Europe increased. Therefore, I expect that as Europe improves its financial position, the TIPS yield will return to zero or above. Therefore, if the market estimate for inflationary expectations described above remains around 250 basis points, then the "regular" 10-year United States Treasury bond should yield at least 2.50 percent. I expect it will go a little higher.

Of course, if the Europeans do not continue to move in the direction of resolving their financial problems, then all bets are off for the 10-year bond yield to rise to above 2.25 percent as the dealers forecast.

But I will continue to go with the assumption that the European financial crisis will continue to lessen in 2013. Note how low the yields now are on the bonds of Greece, Italy, Portugal, and Spain. Some of the "risk averse" money has certainly returned to the continent.

So my expectation of longer-term interest rates for 2013 are tied to the future of the political resolution of the European financial problems.

I still do not expect much pressure on interest rates to come from an economy that is heating up. Elsewhere in the Monday Wall Street Journal, there is report on a survey of economists. This survey shows that, on average, the economists "expect growth of 2.3 percent in 2013, a bit better than the 1.9 percent growth they think was achieved this year."

I don't really disagree with this forecast for 2013. My belief is that real economic growth with be in the 2.0 percent to 2.5 percent range. If this is where growth is, then the real economy will put very little demand pressure on the financial markets. Hence, I don't expect interest rates to rise because of a greater business demand for funds to finance real investment.

Thus, longer-term interest rates will not rise because of a stronger economy, but because of a worldwide restructuring of funds back toward greater risk. The "flight to quality" will be reversed.

Furthermore, there is still no pressure in the short-term end of the financial markets, the money markets, and it looks as if short-term interest rates will remain near zero for the indefinite future. I know, the Fed said that the Federal Funds rate would stay close to zero into 2015. But, there is a big difference between current conditions where the interest rate remains near zero with little or no Federal Reserve actions and the time when demand pressure is pushing short-term interest rates up, but the Federal Reserve has to supply liquidity to the markets to keep the rates down.

And will the Fed be able to keep the longer-term interest rates down? I don't believe so. I believe that the Federal Reserve will be almost totally ineffective in spurring additional economic growth. The economy is growing, but real economic growth will not speed up beyond what I have forecast above, regardless of how many bonds the Fed purchases.

Likewise, I don't believe that the Federal Reserve can overcome the reversal of the "flight to risk." If Europe moves further toward banking and fiscal unity, more and more funds will flow back to the continent. This will cause long-term United States interest rates to rise. I don't believe the Fed can stop this from happening.

Long-term Treasury yields are to rise in 2013. I believe that the 10-year Treasury yield will top 2.50 percent but stay below 3.00 percent.

Source: Will Long-Term Yields Rise In 2013?