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The bond market continues to defy forecasts

(MoneyWatch) COMMENTARY For the past few years, we have persistently heard from the so-called experts that interest rates were sure to head much higher given the Federal Reserve's loose monetary policy. For example, PIMCO's Bill Gross, "The Bond King," announced in March 2011 that PIMCO had eliminated government related debt entirely from its flagship fund, saying that bond yields had reached unsustainably low levels given the scale of government debt obligations and the chance of a correction when the Federal Reserve ended its quantitative easing program. By August 2011, Gross admitted he had made a big mistake. Interest rates continued to fall, defying the forecasts of the vast majority of professional investors, including those of the 16 primary dealers who make markets in government debt.

This year the bond market continues to confound the experts who have been pointing to the Federal Reserve's easy monetary policy and the rapid growth of the money supply. For the 12 months ending in March, M1 has risen more than 17 percent and M2 has risen almost 10 percent. Let's see what has actually transpired.

We began the year with the 10-year Treasury rate at just below 2 percent, and it was still at the same level on March 7. By March 19, the rate had jumped to 2.39 percent. However, the rate has fallen each of the six weeks since.

  • March 26: 2.26 percent
  • April 2: 2.22 percent
  • April 9: 2.06 percent
  • April 16: 2.00 percent
  • April 23: 1.96 percent
  • April 30: 1.95 percent

And on Friday, it closed at 1.88 percent, marking the seventh straight week that the yield on the 10-year Treasury note has fallen. It would also be about 1.5 percent below the level at which Gross had said rates were surely headed higher and investors should avoid all but short-term bonds. Investors who believed the forecasts that rates just had to go higher not only failed to earn the term premium, but they have also been faced with reinvestment risk as rates fell.

While there's certainly the risk of rising interest rates, the historical evidence demonstrates that the only real value of economic forecasts is as fodder for my blog. Prudent investors (as opposed to speculators) know that the market, as reflected in the current yield curve, is a difficult competitor. And the yield curve is currently quite steep, reflecting the view that rates are likely to go higher. Thus, you can only benefit from staying short term if rates rise more than already expected. Informed investors also know that the historical evidence demonstrates that steep yield curves have historically rewarded investors who have taken term risk.

My advice is always the same. First, ignore all interest rate forecasts. Second, as discussed in The Only Guide You'll Ever Need for the Right Financial Plan, the amount of term risk you take should be reflective of your ability to take the risk of unexpected inflation. For retirees, that ability is generally low. For younger investors, especially those with fixed rate debt (such as a mortgage), the ability is much greater. A reasonable strategy for most people is to build a laddered bond portfolio of about 10 years (or use an intermediate bond fund). That balances the two risks of reinvestment and inflation.

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