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

Jun. 21, 2013 6:16 PM ETBKLN, HYG, VCIT, VCLT, VCSH49 Comments
Richard Shaw profile picture
Richard Shaw

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

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

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

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Richard Shaw profile picture
Richard is the managing principal of QVM Group LLC, a fee-based investment advisor based in Connecticut, with clients across the country. . QVM manages portfolios uniquely designed for each client on a flat fee basis through the client’s own accounts at Schwab; and provides investment coaching to "do-it-yourself" investors. The investment approach is based on value, asset allocation, expense control, risk management, customizing portfolios to each client's specific circumstances, and regular communication about strategy and absolute and benchmark performance.   Richard's extensive experience includes having served as a Board Director of Phoenix Investment Counsel, a U.S. pension and mutual funds manager, now Virtus Investment Partners (New York Stock Exchange: VRTS http://www.virtus.com); as Managing Director of Phoenix American Investment in London; and as a Board Director Aberdeen Asset Management PLC in Aberdeen Scotland (http://www.aberdeen-asset.com  then listed London Stock Exchange, now a subsidiary of Phoenix Group inthe U.K.).  He has been a Trustee of a $500 million pension fund, and was a charter investor and member of the Board of Directors of several internet companies, including Lending Tree (NASDAQ: TREE http://www.lendingtree.com) prior to its IPO.   He is a 1970 graduate of Dartmouth College.   QVM Group LLC is a Registered Investment Advisor.   Visit the QVM Group website (http://www.qvmgroup.com) or its blog (http://www.qvminvest.com).

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