Most individual investors are mostly wrong most of the time... It's a phrase I borrowed from well-known economist Dr. Marc Faber. The available evidence is pretty damning - for instance, individual investors captured only about one-third of the gains during the great secular bull market of the 80's and 90's, according to Dalbar, a Boston research firm, returning a mere 5.23% per annum from 1984 through 2000 even as the S&P 500 returned 16.3%. Behavioral finance explains much of what's wrong with the decision making among individual investors. The heuristics used by people to get through life - stereotypes, intuition, rules of thumb, just don't work well when investing. For instance, it turns out that good companies often make bad investments and that bad ones often make very good investments!
But we wrote about all of this in the 4th quarter of last year; why bring it up again so soon? Because individual investors piled into bond funds at a record clip last year and anecdotal evidence suggests that they are still at it even though the bond market is likely to get hammered hard here starting sometime this year if the economic recovery is for real. The 10-year Treasury has already risen steadily from its intra-day low of 2.06% set on 31 December 2008 to a current level of 3.74%. It will likely challenge it's 2008 high of 4.25% in short order. A move above 4.25% opens the way for a run into the high- 4s, a decidedly unappealing development for bond investors and home buyers alike.
What is the fundamental argument for higher interest rates though? Well, it centers around basic supply and demand dynamics. The U.S. government is likely to run a $1.4 trillion deficit this fiscal year (10% of GDP) and foreign investors can only be expected to absorb about $300 billion, leaving a monstrous $1.1 trillion of debt for domestic investors to finance. There aren't enough domestic savings to absorb that much new supply, which means interest rates will rise as demand fails to meet supply. Last year the Federal Reserve bought most of a similar amount of supply, but Bernanke is on record as saying the Fed is done with its quantitative easing and is out of the market.
A second fundamental argument for rising rates centers on the expected economic recovery. An expanding economy requires an increase in the velocity of money, assuming a constant money supply. Inflation will rise (and with it interest rates) as the velocity of money accelerates unless the Federal Reserve successfully reduces the money supply in a timely fashion, which will require them to raise short term rates aggressively. The combination of huge new supply and an expanding economy will likely prove a toxic mix for bond investors.
A second possibility, of course, is a failure of the economy to maintain a strong growth trajectory as the existing heavy debt load remains too onerous to allow any economic momentum to persist. A slide back into recession late this year or early next (our forecast) will result in continued huge deficit spending by the U.S. government and even more supply hitting the Treasury bond market as result. The Federal Reserve is highly likely to re-enter the bond market either directly or indirectly (with an assist from Treasury - courtesy of taxpayer money - through Fannie Mae and Freddie Mac for example ). The result of the latter scenario would be continued low rates (although not necessarily falling rates) for another year or two. The one major fly in the ointment in the second scenario hinges on whether foreigners will continue to support the dollar in the foreign exchange market. There is increasing evidence that foreign central banks are slowly edging away from the dollar as a reserve currency. A run on the dollar would likely cause interest rates to sky rocket as the U.S. is forced to beg for bond investors to take debt off its hands at any price.
Either way, interest rates are set to rise sharply over the next five to ten years; it's only a question of whether that climb begins now, on the back of a sustained economic recover, or in a few years, after another round of heavy fiscal and monetary stimulus. Bond investors will need to decide when to lighten up on bonds because those who stay in the Treasury bond market overly long will almost certainly get flattened by the approaching runaway train.
Individual investors, who increasingly seem to believe that Treasury bonds are a risk free investment, will wake up one day to the awful realization that they can lose large amounts of money in the bond market too....
