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Next Rise in Interest Rates Will Come in 2015

Even when rates finally do head up, they won't zoom out of control. A progressive series of stair steps is more like it.

With the Federal Reserve reducing the extraordinary bond purchases it has made for the past five months, you’d think that bond prices would fall and interest rates would rise. But that hasn’t been the case, even as the Fed has trimmed its purchases by $10 billion every six weeks since January. Instead, 10-year Treasury bond rates have dropped from 3.0% to 2.6%.

The slow economy in the first part of the year was a factor in the decline in rates. But there are a number of reasons for bonds' surprising strength. A close look at them provides some guidance on where interest rates will head, even as economic growth picks up speed.

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First, investors have observed that the so-called taper — the Fed’s gradual reduction in bond purchases — has no bite. Interest rates haven’t risen. Plenty of other buyers, foreign and domestic, have stepped in to take the Fed’s place in bond markets. Moreover, Treasuries are still considered the world’s safe haven. So buyers remain optimistic about prospects for bonds in the near term.

Second, Treasuries were and remain attractive relative to low-yield European and Japanese bonds. In fact, yields on many European bonds have become ridiculously low compared with what they were just a few years ago, leaving U.S. Treasuries looking underpriced by comparison. With Europe’s poor economic growth and near-zero inflation rates likely to persist for the rest of the year, that will continue to be the case.

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Third, for investors seeking safe, reliable places to park their cash, Treasury alternatives are scarce. Long-term municipal bonds, for example, are in short supply, as states and local governments undertake fewer projects, turning their fiscal attention instead toward shoring up underfunded government employee pensions.

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Finally, some investors, eager to lock in some of the extraordinary stock market gains of the past few years, find Treasuries attractive. That’s especially true of private pension funds, which aim to match their long-term liabilities with long-term assets.

Looking forward, none of these factors is likely to change much over the next six months. In addition, there are demographic factors which will help buoy demand for bonds. As my Kiplinger colleague Jeff Kosnett notes, “The older the U.S., Canada, Europe and Japan get, the greater will be the demand for securities, such as bonds, that pay reliable investment income as opposed to those that offer uncertain returns.”

Now that it’s clear the Fed’s bond-buying taper isn’t a factor, the next preoccupation of investors is likely to be guessing when the Fed will start raising short-term interest rates. We expect long-term rates to jump by a half-point or more next year, as investors become nervous about the potential impact of rising short-term rates and a reawakening of inflation. That would cut the value of a typical bond index fund by 2.5%-3%.

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But don’t assume that rates will continue to climb at that pace. Interest rates typically move in stair-steps — often coming a bit later than expected and then plateauing for longer than circumstances might warrant before making another stair-step move up. So odds are the likely jump in 2015 won’t set off an immediate run upward. Instead, rates will stabilize at the new higher level as investors’ nervousness wears off. After all, the Fed will move slowly and cautiously, and the reasons outlined above for continued underlying strength in demand for bonds will remain in place.

Thus, we look for 10-year Treasury bond interest rates to hover in the 2.6% to 2.8% range for a good part of this year, climbing slowly in the later part of 2014 to reach 3.0% at year-end. Then, however, we anticipate a sharpish jump of a half-point or more in 2015 before rates level off again for a while. Because the exact timing will depend on when investors feel that the Fed is likely to stir from its long slumber on short-term interest rates, bond prices and rates are likely to be affected negatively — if temporarily — by any reports of better-than-expected economic strength or inflation.

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