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In RT#25867 I posted my 2005 bond market forecast.
I just noticed that the discussion of the 10 year note is confusing
because it switched between discussing yields and prices without
warning.
Below is a corrected version of the forecast which discusses the 10
year note in terms of yield only.
Carl
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THE U.S BOND MARKET IN 2005
Our first long term bond forecast was published on December 29,1982
when the 10 year treasury note was yielding 10.47%.
The thesis of that forecast was that a new long term cycle in bond
prices and interest rates had begun at the September 1981 peak in
long term interest rates when the 10 year treasury note was yielding
15.84%. We expected the new cycle to evolve in a way similar to the
cycles that had begun at the two previous long term peaks in interest
rates in 1857 and in 1920.
We quote from the December, 29, 1982 forecast: "If the bond market
follows the average of these two historical cycles then bond prices
should be in a generally rising trend for the next 30 years. The peak
in bond prices and the low in long term interest rates is not due
until the year 2010…..long term bonds are once again a high return,
long term investment vehicle and will remain so for a generation to
come."
It is our view that this predicted 30 year, long term downward cycle
in the 10 year note yield has yet to be completed. This contrasts
with today's conventional wisdom which holds that both stocks and
bonds are "trash", i.e. both financial instruments should be expected
to yield subnormal returns for the indefinite future.
Our own "contrary opinion" is based largely on the belief that the
long end of the Treasury market has yet to price in a long term lull
in inflation (another contrary opinion of ours!) and that when it
does the 10 year notes will be yielding less that 3.00% AND less that
the Dow Industrials. ( Currently the 10 year note is yielding 4.27%
and the Dow 2.25%.)
Our shorter term forecasts (1 to 3 years ahead) are based largely on
hypothesis that the duration and extent of bull and bear markets show
a certain consistency over the years. This forecasting technique we
developed from a study of the late George Lindsay's methods for
forecasting stock prices and it has served us well. We admit that we
rely as much upon art as upon science in making these forecasts. They
are a series of educated guesses based upon the market's historical
record and informed by our own market forecasting experience of
nearly forty years.
The current situation in the interest rate markets is unprecedented
in the post World War II era of activist montetary policy in the USA.
In 2003 the Federal Reserve drove short term interest rates to levels
(under 1%) normally associated with depressions and last seen in the
US in the 1930's and 1940's. We believe the 2003 low of 0.80% in
three month t-bills was well below what could resonably be regarded
as normal (perhaps 2.50%) for the level of economic activity at the
time. This situation was reflected in the abnormally steep yield
curve which in mid-2003 had the 10 year notes yielding 275 basis
points more that the 2 year notes.
The interest rate cycle which began from the 2003 lows will therefore
look quite different from past cycles associated with economic
expansions. This difference will show up largely in yield curve
behavior. The curve is stll quite steep as this is being written, but
not abnormally so, and our best guess is that the yield curve will
continue to flatten until we see 2 year notes yielding less that 3
month bills (an "inverted" curve) while the spread between the 10
year and the 2 year notes will narrow to essentially zero.
Put another way, we think that the short end of the market
(securities of less than 2 years maturity) will show steadily rising
rates with only occasional multi-month interruptions until sometime
in late 2006 or in 2007. On the other hand, the long end of the
market (10 year and longer maturities) will on average show steady
yields during the same period.
Now for a more detailed look at short term rates. For this we will
use the 3 month treasury bill as our interest rate index.
For the past 50 years the 3 month bills have marched in tune with
what Lindsay would have termed two long term time periods. The first
averages 12 years 4 months from low to high or from high to low,
while the second averages 14 years 3 months from low to high or from
high to low. To illustrate this principle we observe that the
November 6, 2000 high yield of 6.24% occurred 14 years 1 month after
the low yeild of 5.05% on October 6, 1986. Moreover, the June 19,
2003 low yield of 0.80% occurred 14 years 3 months after the high
yield of 9.10% on March 27, 1989.
The next base point for this calculation is the low yield of 2.61%
which occurred on October 1, 1992. Adding 14 years 3 months brings us
to January 2007 as the ideal time for the next yield high in 3 month
t-bills.
Moves from low to high in 3 month bill yields typically last either
an average of 26 months or an average of 42 months. August 2005 is 26
months after the June 2003 low yield of 0.80%. Mooreover, February
2005 is 12 years 4 months after the low yield of October 1992.
Therefore we estimate that about May of 2005 the Fed will temporarily
suspend its move towards high rates, offering as its reason the
assesment that rates at the time are consistent with non-inflationary
growth. However, this suspension will last only a few months and will
be followed by a move to a tighter monetary policy and this tighening
will conitnue to January 20007, 43 months after June 2003.
How high will the 3 month bill yield be in January 2007? The last
four trends from lower to higher rates carried the 3 month bills up
an average of 340 basis points. This mechanically projects a yield of
4.20% in January 2007. But we must remember that the 2003 low yield
was abnormally low and that therefore the current yield upmove should
tend to be in the upper part of the range of historical experience.
The 1986-89 umove in yields sent 3 month bill rates up 405 basis
points and it is this that we choose as our best guess for the
current cycle. Thus we expect the 3 month bill yield to be 4.85% in
January 2007 (versus 2.25% currently).
We next turn to estimating the yield trend for the 10 year notes.
In this market we find that the 10 year decennial pattern offers some
insight, at least if one is careful to use only those precedents
which occur in the same part (currently falling ) of the 60 year
interest rate cycle. These then would be the years 1984-87 and 1994-
1997 since the 60 year interest rate cycle started downward in late
1981.
In our 2004 bond market forecast we estimated that the bear market in
the long bond prices which began from the June 2003 low yield of
4.14% would end sometime between July and September 2004 with the
high yield on the long bond between 5.88% and 6.04%. This would have
been consistent with the 10 year cycle indications of a high yield
sometime between May 30 (1984 precedent) and November 7 (1994
precedent), averaging out to about August 20.
In the event the long bond reached a high yield at 5.60% early in May
2004 and has since moved toward lower yields (currently 4.86%). The
10 year note reached a high yield of 4.89% in May 2004 and now yields
4.27%. For the past several months we have been expecting these
markets to surpass the high yields reached in May 2004. However, a
more careful analysis of the historical data has convinced us that
the start of this move up in yields will probably be delayed until
the third quarter of 2005.
The first and most obvious clue is that the 10 year pattern predicts
that 2005 will be a bullish year for the 10 year note prices and that
yields will probably drop until January 2006 (1996 precedent) or
April 2006 (1986 precedent).
The long time period for notes averages 13 years 11 months. The May
2004 high yield was 14 years 9 months from the August 1989 low yield.
Adding 13 years 11 months to the October 1990 high yield gives us
September 2004 for a predicted yield low. However, after a yield
high like the May 2004 high yield associated with the long time
period of 14 years the market generally declines in yield for 20
months. This would predict a yield low for January 2006.
Unfortunately this would be out of the historical range of the long
time period which generally does not last more than 14 years 10
months. We therefore compromise on August 2005 as the predicted time
for the low yield in the notes.
We next observe that a low yield in the 10 year notes occcurred in
October 1993. Adding 13 years 11 months to this date brings us to
September 2007 as a projected high yield for the notes. On the other
hand, the 10 year pattern predicts high yields either for August 2006
(1996 precedent) or October 2007 (1987 precedent). The average of
these last two projections is March 2007, quite comparable to the
January 2007 projected high yield in the 3 month bills. Finally,
yield rallies in the notes from important lows (such as the one
predicted for 2005 or early 2006) average about 15 months in length
thus indicating a yield high around November 2006 (15 months after
August 2005).
Putting these observations together we make the following deductions.
First the drop in yields from the May 2004 highs is not yet complete
and will probably continue until August 2005. This date is 18 months
after May 2004 and is as close as we can get to the yield lows
predicted by the 10 year pattern (January and April 2006) without
violating the range of historical experience for the 14 year period.
>From the predicted yield low in August 2005 yields will move up for
about 15 months (the average duration during the declining phase of
the 60 year cycle) until November 2006. We prefer this to the March
2007 date given by the 10 year pattern because the high in short
rates (predicted for January 2007) typically follows the high in 10
year yields during the falling part of the 60 year cycle.
How low will the 10 year yield be at the projected August 2005 yield
low? We do NOT expect the notes to drop in 2005 below the 3.07% low
yield reached in June 2003. Instead we think the 10 year notes will
drop to about 3.60% by August 2005 and then rally to 5.20% by
November 2006.
>From projected yield highs in late 2006 or early 2007 all the
interest rate markets should move towards lower yields for about two
or three years. That drop in yields should carry the 10 year notes
below 3.00% and end the declining phase of the 60 year interest rate
cycle that started in 1981.
Carl Futia
Copyright 2005
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