While the Fedhas virtual control overshort-term interestrates, it has little control over intermediate- and long-term rates. In an effort to drive down long-term rates as well, the Fedinitiated Operation Twist, under which it sells short-term bonds and buys long-term bonds - but markets haven't cooperated. The 10-year Treasury bond rate actually rose to 2.43% from 1.88% in the five weeks following the announcement of the program in September 2011.
For further evidence, go back to March 2007. The economy was going strong and the Fed had inflation fears. To slow the economy, the Fed pushed up the fed funds rate, forcing short-term interest rates up. Markets didn't take the bait, and the typically positive sloping yield curve turned negative. It turns out the markets were right, as inflation didn't raise its ugly head.
UNCERTAIN FUTURE
While it appears likely the Fed will keep the overnight rate near zero for a while, what will happen to intermediate- and long-term rates? The mean forecast of 46 economists surveyed by The Wall Street Journal is that the 10-year Treasury note will rise to 2.26% by December from its recent level of 1.75%. That's a significant increase that, if it happens, would cause longer-term bonds to turn in a significant loss.
But how certain are these economists? Not very. While on average they predicted a 2.26% rate, the variance ranged from a low of 1.5% to a high of 4.34%.
Even their average forecast has a dismal record. According to Bianco Research, these esteemed economists have, as a whole, predicted the direction of long-term rates correctlyless than half the time. In other words, they have been less accurate than a coin flip.
Before reading a lot of bond market research, I felt uniquely qualified to forecast interest rates in the wrong direction. But it turns out I'm just another face in the crowd.
Oddly enough, the top economists' dismal track record doesn't seem to affect their confidence. John Silvia, the chief economist for Wells Fargo and one of the economists regularly surveyed by TheJournal, declared on May 5, 2011, that rates would definitely go up for the rest of that year.
In actuality, the five- and 10-year Treasury rates both plummeted far more than one percentage point from an already historic low level.
GUIDING CLIENTS
In helping our clients understand investing in bonds, there are three conclusions planners can make:
*We can't simply assume that intermediate and long-term interest rates will remain low for another two to three years.
*We also can't assumethat the bond bears will finally be right.
*Perhaps most important, we can be absolutely sure bonds won't have the stellar returns of the last five to 10 years.
I call my third conclusion the Bond Party Is Over prediction. It may sound like a bit of hypocrisy on my part since I have just recited the dismal record of those who make predictions about bonds. But the Bond Party Is Over prediction is based on some math and logic.
The Vanguard Total Bond Fund (VBMFX), which aims to replicate the Barclays Aggregate Bond Index, gained an average of 6.47% annually over the five years ended Sept. 30, 2012, according to Morningstar. It would take continuing declining rates to produce a return anywhere near its five-year average return, but the fund's yield recently was just 1.6%.
SIMPLE MATH
Given the fund's duration of 5.1 years and using some simple math, a 6.47% return over the coming year would put interest rates very close to zero.
Thus, the bond party can't go on for much more than another year, unless we enter a negative rate environment. I'm betting no one will lend $100 with the promise of getting back $99 in one year (although this has begun to happen in some of the stronger European countries using the euro).
It may seem more than obvious that bonds can't deliver the handsome returns of the 30-year bond party for much longer.Yet many forecasts, including those using sophisticated Monte Carlo simulations, still assume bonds will return their historic average of 5.41% for the 10-year Treasury.
