Comments Off on Against the Herd: Lower Rates Rather Than Higher Rates In 2014

Against the Herd: Lower Rates Rather Than Higher Rates In 2014

Bloomberg News surveyed banks and securities companies on where the 10-year Treasury yield would finish 2014. Economist forecasts averaged 3.41%. With 2013 closing near 3.01%, perceived strength in the underlying U.S. economy, and the Federal Reserve reining in its controversial bond buying program (”QE3″), the predictions are hardly outlandish.

On the other hand, where in the media will you find bond bulls who believe that interest rates will go significantly lower? Does anyone think that rates could tumble back towards 2%, or even 1.5%, sending bond prices surging back to record highs?

It is worth noting that gains for treasuries in the first few weeks of January are the strongest that they’ve been in four years. In fact, income ETFs of all flavors are seeing capital appreciation and seven of ten have climbed back above respective long-term (200-day) trendlines; only the three Treasury Bond ETFs remain below respective moving averages.

Could Income ETFs Be Signaling Lower Rates Ahead?
Approx YTD % Above 200-Day
Vanguard Extended Duration (EDV) 4.7% -3.4%
iShares 20+ Treasury (TLT) 3.0% -2.4%
PowerShares Preferred (PFF) 2.9% 1.3%
Market Vectors High Yield Muni (HYD) 2.6% -0.9%
SPDR Barclay Muni (TFI) 1.8% 1.5%
PowerShares Emerging Market Sovereign (PCY) 1.5% 0.0%
iShares 7-10 Year Treasury (IEF) 1.5% -1.3%
SPDR Barclay High Yield Bond (JNK) 0.7% 3.6%
PIMCO 0-5 Year High Yield Corp (HYS) 0.4% 3.4%
PowerShares Senior Bank Loan (BKLN) 0.4% 1.8%
S&P 500 SPDR Trust (SPY) -0.3% 9.6%

Perhaps ironically, the gains for income ETFs in the first part of 2010 is eerily reminiscent of the way that the bond markets anticipated the end of the first round of quantitative easing (”QE1″) six months in advance. At the start of 2010, it was well known that QE1 would be coming to a close in June. Yet a “soft patch” in the economy sent stocks reeling for a 15%+ correction in the summertime. Then the U.S. stock market welcomed July’s announcement of a second round of quantitative easing to commence in August (”QE2″). The news fueled stock gains throughout the 2nd half of that year.

SPY 2010

I am not “predicting” a 1st half correction for stock assets in 2014. Nevertheless, if earnings guidance turns out to be weak, or if income ETFs continue to march higher on price gains, or if incoming jobs data are poor for several months, do not be shocked by any hesitation on the part of investors to purchase riskier assets on the dips. Instead, lower stock prices combined with higher bond prices (lower bond yields) might force Chairwoman Janet Yellen to suspend a tapering increment; if a stock correction is severe enough, Yellen’s colleagues may vote to increase its monthly bond purchasing activity.

Since I did begin this discussion with the average forecast for the 10-year yield at the close of 2014 (i.e., 3.41%), I will venture an educated guess on where it will finish. I expect a slight flattening of the yield curve to keep longer-dated treasuries (e.g., 10-year, 30-year, etc.) in check, regardless of month-to-month volatility in lengthy maturities. Couple a modest flattening of the yield curve with a historically probable shock to the “risk on” mentality, and I am offering 2.75% for the end of the year. In essence, I expect it to finish rather close to where it is right this minute.

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