Outlook for US Interest Rates

Well that didn’t take long—after losing about 3.5% the prior week, the S&P500 roared back to gain about 3.4%.  As one might expect, the volume during this up week was lower than the volume during the down week—sellers always seem to be a bit more committed than buyers. Volatility dropped back down, also as expected, but definitely not back down to the low levels seen before the big sell-off.

So here we go again—the US equity market is completely overbought and overvalued. Prices are hugging the upper Bollinger bands on the daily and the weekly charts and the cyclically adjusted Shiller PE is back up to nose-bleed levels (levels exceeded ONLY during the peaks reached during the dot-com bubble).

Last week’s economic reports were skewed to the downside. To kick things off, the Empire State manufacturing survey missed  badly—by falling into negative territory instead of rising as expected. The housing market index missed. Housing starts also missed, as did PMI flash manufacturing. Consumer prices crashed, with the headline figure dropping far more than experts had predicted. PMI flash services also missed and the Philly Fed Survey came in below expectations. Only industrial production and initial jobless claims came in ahead of expectations.

Looking forward to 2015, one of the biggest areas of interest to investors is the outlook for the US Treasury market. In 2014, when virtually every economics expert predicted that the rate on the 10 year Treasury note would rise—some predicted a huge rise; some predicted a modest rise—the world was stunned to see that the exact opposite happened. The rate on the 10 year fell from about 3.0% at the start of 2014, to about 2.15% by the end of the year…..now.

So what’s the outlook for this key rate for 2015?

It turns out that many of the same factors that drove rates lower in 2014 are still in effect. For example, the decreased supply of Treasuries from a declining US federal deficit will continue in 2015 where the budget deficit is on track to shrink, again, even more. Also, the need for major financial institutions to beef up their low-risk investment holding is also going to continue—many banks around the world are being forced by new financial regulations to reduce their holdings of risky assets and to replace them with safer assets, and there’s no safer asset in the world than a US Treasury security. Also, the super low rates on other sovereign debt securities (for example, Spain’s—yes Spain’s!—10 year bond is yielding far LESS than the US 10 year note) will pull down the rates on US government debt securities.

How low can rates go?

Well at the very least, they can simply return to the lows reached in 2012, when the US 10 year dropped to the 1.4% range. And that would represent another major move higher in price.

At the extreme, US rates can eventually fall to the levels reached by Germany and Japan. And these rates are ultra-low:  Germany’s 10 year rate us under 0.6% and Japan’s is under 0.4%.

Will such moves down happen quickly and in a straight line? Most likely not. But unless many of the long-term trends, trends that have been in place for several years now, reverse, US Treasury rates can still fall a lot more.

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