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Why Interest Rates Keep Falling

Interest Rates Keep Falling, Prompting Investors to Lock Up Their MoneyOnce again, the markets continue to provide surprises. Defying the forecasts of most economists and market gurus, interest rates have been falling. For example, in early March legendary bond investor Bill Gross announced he had dumped his Treasuries and shortened up the duration of his bond holdings. Let's see how that turned out. On March 1, 2011 the 10-year and 30-year Treasuries were yielding 3.41 and 4.48 percent, respectively. By June 1, they had fallen to 2.96 and 4.15. Thus, the question is: Why are interest rates still falling?

First, economists getting rate forecasts wrong is nothing new, as my MoneyWatch colleague Allan Roth noted yesterday. He mentioned a study by Bianco Research showing that the Wall Street Journal's consensus interest rate forecasts (which involve 60 economists) got the direction wrong 65 percent of the time. (The chapter Why Persistent Outperformance is Hard to Find in my book The Quest for Alpha provides the evidence from other similar studies.)

The overwhelming body of evidence on the inability of forecasters to see the future clearly makes one wonder why people pay so much attention to what is obviously nothing more than the financial equivalent of reading tea leaves or palms.

Second, if you're like most investors, you're wondering why rates have continued to fall, defying the experts. There are two simple explanations. First, the economic news (data on employment, manufacturing, consumer confidence and so on) has been weaker than expected. In other words, economists and gurus called it wrong -- they got caught by surprise. Yet, history teaches us that surprises are a persistently important factor in explaining outcomes. And by definition, surprises aren't forecastable.

The second explanation is that the price of "portfolio insurance" has gone up. Assets that tend to perform well when the risks of stocks appear should have low expected returns. Just how low depends on investors' perception of risk, which is constantly changing. When investors believe the risks are high, they bid up the price of securities that offer portfolio insurance. And since investor perception of risk has been rising with the weakening economic data, they've bid up the price of assets that offer a safe haven from the storm. And that helps explains why yields have fallen.

Because surprises explain so much of bond returns (and equity returns as well), you should ignore the forecasts of economists and gurus when deciding on the maturity of your holdings. Our strategy for nominal bonds is to simply build ladders, typically with average maturity of four to five years, and then stay the course. A ladder provides the benefit of diversifying term and reinvestment risk. The limit of four to five years for the average maturity is based on the historical evidence that term risk beyond that hasn't been well rewarded. Those who have stayed very short over the past two years have paid a large price in foregone interest as the yield curve has been very steep.

Before concluding, I thought I would add the following. Readers of this blog know that my crystal ball is always cloudy. But I will make an exception and provide the following forecast. The economists who had predicted rising rates won't admit their mistakes. Instead, they'll do what they always do. Quoting Carol Tavris and Elliot Aronson, authors of Mistakes Were Made (but not by me), they'll justify their forecasts by "coming up with explanations of why they would have been right if only -- if only that improbable calamity had not intervened; if only the timing of events had been different; if only blah blah blah."

Photo courtesy of Presagio on Flickr
More on MoneyWatch:
Interest Rates: Why Waiting for Rates to Rise May Cost You Why Buying Money-Losing Investments Can Be a Good Strategy Should the Treasury Stop Issuing TIPS? Nouriel Roubini Misses Another Prediction The Smartest Things Ever Said About Beating the Market
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