Why This Bond Rally Just Won't Quit

Predicting interest rates is always a tricky game, but rarely have forecasters been caught off guard as badly as by this summer's bond rally. After yields on 30-year Treasuries hit 7% last spring, most analysts thought the party was over. "Frankly, I thought the long bond was headed back to 8%," admits H. Erich Heineman, chief economist at the investment banking firm of Ladenburg, Thalmann & Co. "I never imagined it would crack 6%."

But during the first week of September, bonds didn't even pause for breath as rates fell to 5.86% on Sept. 8. Now, bond-market watchers are reexamining their data and asking themselves: How low can they go? The answer, many say, is that the bond rally isn't over yet. Long-term rates could fall to 5.5% or less, and if economic growth stays slow for the rest of 1993, the long bond might even drop below 5% next year.

FEVER PRONE. Such predictions are fueling a headlong rush into the markets. "Speculative fever is causing a lot of money to pour into long-term bonds," observes John E. Silvia, chief economist at Chicago's Kemper Financial Services Inc. "All it will take is another cut in rates by the Bundesbank or another weak employment report to keep the rally going."

Of course, the now-chastened forecasters could be wrong again. A sudden spurt of growth could quickly send rates up. But the economic trends point to continuing downward pressure on yields. Growth remains sluggish throughout the industrial world, U.S. inflation has slowed to 3% or less, and the federal budget deficit is shrinking.

While 30-year Treasury bonds have seen the biggest decline in rates, the bond rally has spread to medium- to long-term issues as well. Yields on 10-year Treasuries--which play a key role in setting mortgage rates--have fallen from 6.9% last November to 5.2% on Sept. 8, the lowest rate in 26 years. Since late May, yields on the 10-year note have fallen nearly a full percentage point, only slightly less than the drop in the 30-year rate over the same period.

ANEMIC GROWTH. The surprising slowdown in U.S. growth is the main reason rates have plummeted. The U.S. economy grew at an anemic rate of 1.8% in the second quarter, short of the 2% to 3% range expected by forecasters. And there's little strength in the Japanese and European economies, either. Indeed, Germany's 10-year bond rates have dropped 60 basis points since June alone, providing strong encouragement for the U.S. bond rally.

Inflation, too, is proving to be less of a menace than many feared. After running at a 4% clip during the first four months of 1993, U.S. inflation has slowed to less than 1% since May. Worries of a new inflationary surge were eased by passage of President Clinton's deficit-reduction plan, and by a Sept. 1 Administration forecast showing smaller-than-expected future deficits.

As many analysts now see it, long rates almost certainly will keep falling if the economy musters less than the 3% growth rate expected for the second half and inflation stays below 3%. David Wyss, research director for DRI/McGraw-Hill, thinks current economic conditions justify a 30-year bond rate somewhere between 5.75% and 5.5%. He argues that the historic gap between inflation and long rates has been around two percentage points. That suggests that if the economy stays weak and inflation slows further, "you could see a 4.5% rate for the 10-year and 5% for the long bond," says Wyss.

Another factor pushing down long rates: the Treasury Dept.'s decision to trim borrowing costs by shortening the maturity of its debt. The Treasury has cut back its sales of 30-year bonds from $36 billion a year to $22 billion, creating demand for 30-year bonds that outstrips supply, driving rates down. Despite falling yields, many pension plans and other investors see no other way to lock in decent returns at a time when bank CDs pay less than 3%. "We're seeing a buyers' panic," says Donald H. Straszheim, Merrill Lynch & Co.'s chief economist. "People are willing to pay a scarcitypremium."

Buyer panics, of course, often reverse direction. If rates begin to rise, bond buyers will face a rude shock. Given the experts' recent track record as crystal-ball gazers, the risk may be bigger than many investors realize. But for now, it might be one worth taking.

Before it's here, it's on the Bloomberg Terminal.