Forecasting the movement of long-term interest rates months in advance is like predicting early in the season which Major League Baseball teams are going to make it to the post season. Given all the variables on the playing field, the outcome is anyone's guess. In the July issue of NREI, four economists that were included in our mid-year forecast predicted that the 10-year Treasury yield would end up at 5.2% or higher by the end of 2006. Barring an unforeseen economic shock, the possibility of that actually happening now seems remote.

As we head into the late innings of '06, economists are now expressing a collective surprise at the rather steep drop in the long-term bond yield in recent months. After reaching 5.25% in June, the yield on the 10-year note slipped to 4.6% by late September. “One reason is that as oil prices have declined in the last month and a half, so has the 10-year bond rate,” observes Dr. Rajeev Dhawan, economist with Georgia State University in Atlanta. “It takes the pressure off inflation.” Indeed, oil futures dropped from approximately $78 per barrel in mid-July to $63 in late September.

The 10-year Treasury yield could be falling for another reason, Dhawan believes. “The bond market may be betting that 2007 will be a lot weaker [economically] than what the stock market is thinking, so bond investors are looking at rate cuts coming down the road.” Dhawan's own forecast calls for a rate cut by the Federal Reserve in March 2007, but he says that could occur this December, if the long-term bond yield doesn't bounce back sufficiently. Bear in mind that the fed funds rate is 5.25%, which means short-term rates are higher than long-term rates. Historically, a prolonged inverted yield curve has meant bad news for the economy.

One of the more conservative forecasters at the beginning of 2006 was Hessam Nadji, managing director of research for brokerage Marcus & Millichap. He predicted the 10-year Treasury yield would register 5% by the end of this year. “The primary reason we did not believe the rate would go up much was the emerging economic slowdown, especially in housing,” Nadji explains. “That turned out to be correct, but the sharp decline from 5.2% to the current rate of 4.6% did occur faster and at a sharper rate than we had expected. That has to do with the employment market slowing more than expected and easing pressure on core inflation, which in turn is giving the Fed a bit more room to pause,” concludes Nadji.

Simply stated, this interest rate drama is a fluid situation with a lot of twists and turns, much like baseball's post-season play.