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Interest Rates – Why Are They Falling?

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Interest rates generally move lower as the economy weakens and recession is feared or likely. That is not the case now. We are in the fifth year of economic recovery, the job market is improving and the Federal Reserve has telegraphed an end to the massive stimulus program.

So, why are rates falling? Good question. Professional money managers began the year fearful of rising rates and advocating short -term bonds or even cash, claiming interest rates had nowhere to go but up. The 10 year US Treasury rate was then close to 3%. It was believed the tapering of government bond purchases and the improving US economy would cause interest rates to rise. Portfolios were positioned for this outcome, not the fall in rates we have see through the first five months of 2014. It is possible these “experts” have panicked and reversed this conservative bet, fearful of being wrong, leading to the drop in rates.

Some speculate that European interest rates are at historic lows and if the US is the “quality” trade our rates should be lower. Others say the supply of US Treasury bonds and notes is limited. Our government bought $25 billion per month of US Treasury obligations for some time and with tax revenues higher the need to issue new bonds is less. This means more dollars chasing after a limited supply of bonds. The most plausible reason for lower interest rates is the hunt for yield. Cash is still generating zero returns. A yield of 2.5% looks pretty good by comparison. It is also possible that Baby Boomers, who are retiring in droves, still believe bonds are the safety trade. Whatever the reason, it will pay to be patient. Interest rates are low and there is still more risk of principal loss with higher interest rates than there is money to be made buying long-term bonds.

The reasons listed here are not significant and only speculation as to why interest rates are lower. Any sign of a stronger than expected US economy or rising rates elsewhere in the world could be enough to cause bond interest rates to rise, sending prices lower. The risk/reward of owning bonds favors risk. There is a place in most portfolios for some bonds but don’t follow the herd or throw in the towel and buy long- term bonds. Interest rates are low and have a good chance of moving higher in the not-too-distant future.