From the December/January 2013 issue of Futures Magazine • Subscribe!

Up or down? Interest rate outlook could be either or both

Risk on/risk off 

McDonald says there still is one more big risk-off trade ahead for the bond markets (perhaps in late 2012/early 2013), but his index of 17 systemic risk indicators that have predicted past market turns remains calm. 

“These indicators were going crazy before Lehman,” he says, adding that they went crazy again in May shortly before the market drop, and last summer when a 20% drop was seen over 34 days. “Now those indicators are calm as can be. So there is definitely lower systemic risk. Banks are trusting each other more,” he says.

McDonald expects the Federal Reserve to lose control over the longer end of the yield curve when Europe later normalizes. “The Fed is being assisted by Europe because they are able to do QE, which lowers rates. If they were doing QE with a normal Europe, they would have a tough time keeping rates low,” he says. 

McDonald says fear is why investors continue to buy U.S. Treasuries under 1.7%. “They are just terrified. Why else would you do it? When that goes away, the Fed has a much harder time controlling the yield curve.” 

Rick Pearson, Zurich-based portfolio manager for Signina Capital AG, says European bond markets “are very artificial” as a result of €80 billion ($102.4 billion) worth of core bond purchases by the Swiss National Bank after the central bank’s sale of Swiss francs to suppress the currency. “I don’t think France, for example, would be trading at these levels without the purchases the Swiss have made,” he says. 

But Robert I. Kessler, CEO of Kessler Investment Advisors, argues that interest rates are likely to continue declining and that the 30-year-plus bull market in Treasuries is still years from ending. Until then, the primary trend of U.S. Treasury interest rates will be lower, although there will be periods of rising yields, he says.

“Rates will continue to ratchet down,” Kessler says. “The question is, how much further can you go?” Examples to look at, he says, include Japan, Switzerland, Northern Europe and Australia.

“Let’s look at countries that really do have substantially lower rates than we have,” he says. “Look at the bund, look at the gilt or look at Australian rates, which are the lowest we’ve seen perhaps ever. We’re not the only ones; it’s not like this is endemic to the United States. It’s a global rate situation.”

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