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Richard Shaw, QVM Group (50 clicks)
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The violent market action this week resulted from investors being surprised by the Fed basically doing what it has been telegraphing for a while now. Yes, they really mean really when they say really.

Nonetheless the Taper-Talk resulted in a Taper-Tantrum. But tantrums and corrections in markets are just part of ordinary fare. As the song goes, "mama said there will be days like this; there will be days like this mama said."

Clearly it is time to think more about where interest rates might go.

It is easier to predict WHERE they will go than WHEN they will go, and near impossible to predict both. We'll stick with WHERE in this letter, except to say we doubt rates will rise to "normal" levels very rapidly because central banks will probably take measures to moderate the rate of change.

It seems to me that the Fed in the back of its mind is expecting 10-year Treasury rates to go to the 4.0% to 5.0% range over the next year or two or maybe three. That would correspond to 30-year mortgages in the range of 5.75% to 6.75% compared to nearly 4% today. The estimated Treasury rate would also correspond to Baa corporate bonds at about 8%.

How do we estimate those rates? … just using long-term averages.

The Fed is targeting 2% inflation. The long-term spread between 10-year Treasuries and CPI is about 2.5% (the "real rate"). That gives 4.5% as a probable target for the 10-year bond.

10-Year Treasury rate (blue), CPI (red) from 1963

(click to enlarge)

Rate spread between 10-Yr Treasury rate and CPI from 1963

(click to enlarge)

Toss in a little over or under accomplishment by the Fed on creating inflation, and you get 4% to 5% as a 10-year Treasury rate.

With a 10-year Treasury at that level, we might likely see 30-year mortgages at about 5.75% to 6.75%, based on an historical 1.75% average spread between Treasuries and mortgages.

10-Year Treasuries (blue) and 30-year mortgages (green)

(click to enlarge)

Baa corporate bonds (bottom of investment grade bonds) might be around 5.85% to 6.85% based on an historical spread of about 1.85% over the 10-year Treasury. The long-term average Baa rate from 1953 is about 8%. Baa bonds are about 5.2% today.

10-Year Treasuries (blue) and Moody's Baa Corp. Bonds (red)

(click to enlarge)

Rates could, of course, be well above or below these levels, but these averages are probably not bad general guideposts … at least levels from which to develop an alternative view.

In any event, "up" is the long-term direction of interest rates, and bonds are not a good place to seek both real or nominal capital preservation and real income (and probably not portfolio volatility moderation) at this time and in the foreseeable future.

To the extent that we are required to hold bonds, we seek authorization to:

(1) reduce the overall allocation,

(2) shorten the duration of the holdings,

(3) focus more on credit risk and less on interest rate risk

(4) seek variable rates over fixed rates.

Bonds have historically been less volatile than stocks, and will surely continue to be so, but their risk reward ratio (total return compared to price fluctuation) is unlikely to be as attractive as in the past 30+ years of declining interest rates. More than 1/2 of the total return from bonds since the interest rate peak in the early 1980s came from price appreciation as rates fell.

Looking forward, the reverse will be true, as rates rise to "normal" levels not held down by central bank action. So instead of returns being interest income plus price appreciation, we face a period interest income minus price declines.

Until recently, we had to talk about bond math to make our point, but not any more. You don't need to know the bond math now, just observe what happened to bonds in the last few weeks as the 10-year Treasury rate rose from less than 1.7% to over 2.4%.

Top Panel: 10-Year Treasury Rate; Bottom Panel: Percent Price Performance of 5 Types of Corporate Bond Funds

Short-Term Investment Grade Corporates (VCSH) red
Intermediate-Term Investment Grade Corporates (VCIT) blue
Long-Term Investment Grade Corporates (VCLT) green
High Yield (below investment grade) Corporates (HYG) gold
Sr Floating Rate Bank Loans (below investment grade) (BKLN) purple

(click to enlarge)

We, and most everybody else, have been warning about coming rate increases and problems with bonds. The problem is upon us now.

Disclosure: QVM has no positions any mentioned security as of the creation date of this article (June 21, 2013). We certify that except as cited herein, this is our work product. We received no compensation or other inducement from any party to produce this article, and are not compensated by Seeking Alpha in any way relating to this article.

General Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.

Source: Fed Targeting 4% To 5% Nominal 10-Year Treasury Yield And Baa Corporates Approaching 7%