Bearish bonds
confound analysts

WASHINGTON -- Nuclear states India and Pakistan are close to war. Argentina's economy and government have collapsed. Terrorist overlords Osama bin Laden and Mohammed Omar are still on the loose. And America is in the throes of recession.

Good time to invest in bonds, right? Tell that to bond investors.

Normally in times of global crisis and economic weakness, investors shun stocks and park their money in safer havens like U.S. Treasuries.

But stocks have rallied recently, while bond prices have fallen, pushing interest rates higher.

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The trend is confounding even the country's best bond forecasters.

Brian Wesbury, vice president and chief economist at Chicago investment firm Griffin Kubik Stephens and Thompson, says everything he's learned has been turned on its head over the past several weeks.

"Retail sales are the worst in 10 years. This tells me to buy bonds and sell stocks," he said. "But the market is doing the opposite – stocks are up, bonds are down."

Wesbury has ranked as the most accurate interest-rate forecaster in both the Bond Buyer and Bloomberg Business News interest-rate surveys, and was rated in 1998 as one of the nation's top economic forecasters by the Wall Street Journal.

Friday's 10-year Treasury yield stood at 5.14 percent, nearly a full percentage point higher than its 4.22-percent low of Nov. 7.

If the trend continues, it may dull the economy's one bright spot – the housing sector, which had been boosted by low mortgage rates.

Mortgage rates historically have tracked the 10-year rate, with a roughly 2-point spread between them.

The 30-year fixed rate for conventional home loans hit a record low of 6.45 percent in November, when the 10-year bond yield averaged 4.45 percent.

But like the 10-year Treasury rate, the 30-year mortgage rate has since reversed course, climbing to 7.14 percent in Freddie Mac's latest survey.

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Wesbury thinks bond investors, who worry about inflation, are overreacting to a spate of good economic news since the Sept. 11 terrorist attacks.

But he calls it a "post-9-11 bounce," and notes that new orders for non-defense durable goods, non-auto retail sales and consumer confidence "are all still below their pre-attack levels."

Even the recent stock-market rally may be illusory, he says.

The three major stock indices – the Dow, the S&P 500 and the Nasdaq – have merely dug out from their losses after Sept. 11, and haven't climbed into new high ground. Stocks historically have followed corporate profits, which remain weak.

Money managers, such as Joseph Balestrino, who runs the $300 million Federated Stock & Bond Fund, doubt investors will continue to abandon bonds for stocks, given the lingering economic and global uncertainties and poor returns from stocks last year. The average U.S. bond index fund returned 6 percent in 2001, compared with a 14 percent loss for the average U.S. equity index fund, according to Bloomberg Business News.

Some analysts speculate, however, that the bond market is reflecting fear that the Federal Reserve has injected too much liquidity in the economy, which could reignite inflation down the road. Inflation, largely a monetary phenomenon, is caused by too much money chasing too few goods.

Bonds react primarily to inflation news.

The Greenspan Fed last year had to rapidly ease credit to adjust for its tightening in 1999 and 2000 to combat what it saw as rekindling inflation –
tightening that many economists now say was unnecessary and a major cause of the recession.

Wesbury, former chief economist for the Joint Economic Committee of Congress, argues that the bigger worry is actually deflation, citing a 10 percent drop in gold prices and a 50 percent drop in scrap steel prices over the past three years.

Politicians here have another theory to explain rising long-term interest rates – the shrinking federal budget surplus.

"The rapidly disappearing surplus is the key reason long-term interest rates have barely budged, this despite the fact that the Federal Reserve cut the short-term federal funds rate 11 times last year," said Senate Majority Leader Tom Daschle, D-S.D., in an economic speech on Friday. "All together, the federal funds rate dropped nearly 5 percentage points last year, yet the 10-year Treasury rate ended the year almost exactly where it had begun."

Daschle blamed the shrinking surplus on President Bush's tax cuts, and pointed out that Bush's own budget director forecasts deficits over the next three years.

Economic studies have failed to show any consistent relationship between budget deficits and long-term interest rates. Historic data do support, however, a correlation between inflation and long-term interest rates.