Return to Normal: 15 Month Bond Interest Rate Forecast

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 |  Includes: IEF, IPE, PST, TBT, TLT
by: Arnold Landy

Assumptions: The U.S. economy will continue to emerge from recession and over the next fifteen months it will grow at an average real rate of four per cent, which is one percent above its historical average. It is normal for the economy to grow rapidly when snapping back from recession and this recovery is showing more and more signs of strength. News of the strong recovery will generate confidence, leading to a further weakening of the "flight to quality" which has exerted downward pressure on interest rates of Treasuries. That, combined with the upcoming increases in the Fed Funds rate will put upward pressure on all interest rates, but particularly those of U.S. Government securities, which have been strongly suppressed by the flight to quality. This forecast assumes that by mid 2011 most long term interest rates will return to more historically normal levels.

Forecast:

Inflation: An inflation rate forecast is essential to any interest rate forecast. Real rates do not fluctuate all that much over the years - the rate of inflation is a constant companion of interest rate levels - they travel together.

CPI Inflation is now running at 2.3%, year over year, with the core rate somewhat lower than that. The trend of inflation is downward, having been at 2.7% for the full year 2009. M2 money supply growth, the feedstock of inflation, is running below 2% year over year. The trend here is also downward. M2 growth has been unusually low because the banks have been reducing net lending. M2 money growth is normally HIGHER than the inflation rate, since money growth must accommodate economic growth as well as inflation. Therefore, the prognosis for inflation over the next year is for it to continue at slightly over 2%, then fall below that, year over year. Declining inflation is bullish for bonds, and will exert a dampening effect on the moderate rate increases which we expect.

By mid 2011, inflation will depend on future money growth plus cyclical pressures generated by a growing economy. M2 growth will increase noticeably once bank lending expands later in 2010, as banks, businesses and consumers gain confidence in the economic rebound. Then, after some lag, the rate of inflation will creep back toward its recent historical range of 3 - 3.6%. The slow reawakening of inflation implies that corporate interest rate increases will not gather steam until 2011, at the earliest. However, Treasuries face more rapid increases in rates, as the flight to quality ends.

Treasury 10-Year Note: This rate will gradually move up toward its 2006-2007 average of 4.72%, but will not go above that level. The annual average rate for the 10-Year has not been above 5% since 2001, when the surging economy was ending a nine year boom. The current rate stands at 3.89%, as of April 2, 2010. A return to its 2006-2007 average implies a boost of 83 basis points. That would hurt existing holders of these notes. Spikes in the rate will occur as news on the economy is more and more positive. Such news will exert upward pressure on the 10-year rate by mitigating the flight to quality, which has kept all Treasury rates unusually low, relative to corporates.

Treasury 30-Year Bonds: The rate on 30-year Treasuries, 4.76% on April 2, 2010, ALREADY has nearly matched its 2007 average, and stands only 15 basis points below its annual average during 2006. However, the relatively flat yield curve at long maturities in 2006-2007 was an unusual condition. Today's unusually steep yield curve is, likewise, a most unusual condition. A return to a more normal slope in the yield curve gives us a forecast value of 5.02 %, which is 26 basis points above its current rate.

Corporate Bonds, Long Term AAA: This rate, which stood at 5.36% on April 2, 2010, is the Average Moody's Yield on Seasoned Corporate Bonds - All industries - AAA, as shown in the Fed's H.15 release, "Selected Interest Rates." The current rate is close to its 5.58% annual average of both 2006 and 2007. Applying a normal spread of 86 basis points above our forecast value for the 10-year Treasury gives us an identical value of 5.58%. So, we forecast a rise of 22 basis points in the rate of Long Term AAA corporates to 5.58%.

Corporate Bonds, Long term BAA (Medium Quality, Investment Grade): This rate, 6.35% as of April 2, 2010, for the Average Moody's Yield on Seasoned Corporate Bonds - All Industries - BAA, as shown in the Fed's H.15 publication, "Selected Interest Rates," is lower than it was in 2008-2009, when investors' "flight to quality" drove the average rate on these securities well over 7%. The current rate nearly matches its 6.48% average annual rate during both 2006 and 2007. Adding a normal spread of 180 basis points over our 10-year Treasury forecast rate gives us a forecast rate of 6.52 % for BAA Corporates This implies a narrowing of that spread from its current 246 basis points, as the economy improves, investors gain confidence, and bond investors become less wary and more complacent, as they tend to do.

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Investment Implications:

1) Avoid long term AAA corporates, until their yield rises to approximately 5.58%.

2) Avoid the 10 year Treasury. Along with Treasury Bills and short term Treasuries, the 10 - Year Treasury Note has benefited mightily from the financial panic's flight to quality. As its rate rises with a return to normal credit conditions, this security will decline the most in value among those evaluated in this forecast. Would be buyers should stay away until the end of the flight to quality raises the yield on these notes near 4.72%.

Stock investors who are tempted to short the 10 - Year Note by buying the Proshares Ultrashort 7-10 Year Treasury ETF (NYSEARCA:PST) are warned that this security tracks double the inverse of the notes on a daily basis, only. Long term holders may be tripped up by the rolling over of contracts to future months, which may have higher interest rates already built into their pricing structure. We are NOT recommending purchase of PST.

Futures traders are likewise warned that higher interest rates are built into the current prices of futures contracts on 10 - Year Treasuries. Thus, the September, 2010 contract price reflects a substantially higher interest rate value than the current front month of June. Short speculators here would be betting on rate rises that are even higher than those already assumed by current futures contract pricing.

3) Avoid medium grade BAA long term corporate bonds while their yield remains below the forecast value of 6.52%. These lost value during the flight to quality, then rebounded as the economy improved and credit worries declined. They will decline in value as rates return to historically normal levels. Buyers must keep one eye on M2 growth and any rise in the inflation rate. They must keep their other eye on any softening in the economy, which could spur another flight to quality and depress the value of these bonds.

4) Avoid 30 year Treasuries while their yield is under the forecast 5.02%. They already pay interest at a rate that is close to their 2006-2007 average, which was depressed by the flatness of the yield curve in those years. But, rising rates amid the continuation of a positive yield curve, even with some flattening from today's extreme slope, will drive yields on the 30 - Year Treasury beyond the levels of 2006-2007, leading to a decline in the value of existing bonds. Investors in long term Treasuries must not only pay close attention to signs of future inflation, but also must attend to the issue of credit risk, as any significant worsening in the U.S. Government's fiscal outlook could threaten the Treasury's credit rating and investors' bond values.

5) The thirty year bond bull market is over. Bond investors must deal with low yields as they keep duration short. As interest rates rise, a return to "normal" bond rates, as outlined in this forecast, may provide entry points to purchase long term bonds. But such investors must keep an eye out for early signs of increasing inflation, which will be a particular threat to bonds' current high valuations, which reflect the steady decline of inflation in recent years. As always, bond investors must also watch out for deterioration in credit quality. Also, Treasury investors must keep a close eye on our government's progress in getting its fiscal house in order, lest Treasuries lose their AAA status.

What could go wrong and worsen this forecast? The main danger is that the Federal Reserve could keep rates too low for too long, and print too much money in doing so. This would cause inflation to grow out of control. A soaring rate of inflation would hurt the value of all bonds. In that scenario, safety would lie in Treasury bills, money market accounts and Treasury Inflation-Protected Securities (TIPS).

Common stocks would rise in value over time to reflect inflation in their earnings and assets, although they could be subject to sharp declines along the way if out-of-control inflation puts economic growth at risk.

Disclosure: No positions