Just because rates haven't risen doesn't mean they won't.

    Every January since 2003 the conventional wisdom of financial experts has been that the one certainty they all agree upon is that interest rates will soon head north. So far, they've all been wrong.
    Finally this past May, the nation's largest fixed-income manager, Pimco's Bill Gross, became among the first prognosticators to throw in the towel and reverse himself, concluding that the forces of disinflation would triumph over those of reflation. Speaking at Morningstar's annual conference in late June, Gross told attendees he expected the Federal Reserve Board to stop raising the fed funds' rates at 3.50%, and he predicted that the ten-year Treasury would trade at a yield of between 3.00% to 4.50% for the next three to five years and that inflation would decline from about 2.5% to the 1.0% area in the next few years.
    No sooner had some of his competitors reached similar conclusions then a raft of economic data came out suggesting that the economy was emerging from its so-called soft patch and shrugging off a 50% increase in the price of oil from the start of the year. Even Gross amended his position, saying one month later that it was possible the fed funds rate could go to 4.00%.
    But the reason that markets continue to defy experts and policymakers like Fed Chairman Greenspan goes beyond the simple triumph of disinflationary forces. Other factors causing this conundrum include the rising demand for and shrinking supply of bonds, the hedge fund explosion, the willingness of investors to accept lower rates of return and high global savings rates, particularly in Asia.
    Corporations cut capital spending and deleveraged their balance sheets for several recent years while dramatically increasing their cash flow, notes Steve Bohlin, managing director at Thornburg Investments. At the same time the U.S. federal budget deficit appears to be falling from $500 billion in 2003 to about $320 billion. Finally, he thinks both retail and institutional investors are looking to fund their retirements with more predictable vehicles than small-cap equities.
    At the heart of the debate is the health of the U.S. economy, which some think is too dependent on housing. "The leverage inherent in housing frightens me and others," Gross told Morningstar attendees. "But we need the housing market to stay above water to support ongoing consumption. Sadly, that's not the route for a healthier, wealthier nation, but it is a necessary thing."
    Unfortunately, it may not be sustainable. J. Michael Martin, an advisor at Financial Advantage in Columbia, Md., fears that at some point the housing bubble will burst. "It's amazing how consumer spending is dependent on rising house prices," he says. "Housing makes up one-third of all employment growth in recent years. In 2004, half of the growth in consumer spending was cash-out refinancings and home equity loans."
    If those sources of capital dry up, Martin thinks a recession or slowdown could be looming in 2006 or 2007. Additionally, the flattening yield curve has worrisome implications. "Think of how much more the hedge funds have to be leveraging themselves to maintain returns," he warns.
As with technology with 2000, the fear that when housing cools off, no other industry will be able to pick up the slack is widespread. It also may be overblown. But unlike Gross, who has consistently underestimated the strength of the U.S. economy for a decade without letting it hurt his funds' performance, Bohlin sees an economy that that has come out of its 2000-2002 funk, "We've had 13 consecutive quarters of better than 10% earnings growth," Bohlin notes. "That's not an economy on its heels. All basis industries outside of manufacturing are doing well and some are adding jobs."
    Bohlin believes that the housing and residential real estate markets, representing 6% of gross domestic product, will taper off at some point but won't necessarily take the rest of the U.S. along with it. That's a significant statement, because if one adds up all the businesses related to housing, it amounts to almost 15% of GDP.  "But if that falls to 10%, it doesn't mean housing prices will drop, say 20%," Bohlin says. "I don't even know if it drops; maybe it just flattens out."
    Loomis Sayles chief economist Brian Horrigan thinks the economic expansion "has everything it needs to go until the end of the decade" and he thinks Gross' prediction that at some point in 2006 or 2007 the ten-year Treasury yield could fall to 3.0% or 3.5% is misplaced. "The only time that yield got to the 3.00% area was in late 2002 and early 2003 when we were coming off of bankruptcies at Enron and Worldcom, a recession, preparing for the Iraq invasion while worrying about deflation and downward pressure on wages," Horrigan, who thinks the ten-year Treasury will hit 5.0% some time next year, says. "Every quarter since then, GDP has grown at 3.0% or higher. By 2004, there was an inflation panic but some people like Bill Gross, [ISI's] Ed Hyman, and [Morgan Stanley's] Steve Roach are still stuck in a deflation panic. Unemployment is at 5% and the labor market still has slack, while the economy has handled the surge in oil prices very well."
    Many observers disagree with Gross' contention that disinflation will vanquish inflation. "Oil and commodities and U.S. capacity constraints make the inflationary trend more powerful," says Bill Davison, managing director in charge of fixed income at The Hartford's mutual fund group. "Also, the global capacity in Asia is no longer as deflationary as it once was. China has modest inflation now. We don't see rampant inflation, but we see upward pricing pressure."
    After slashing capital spending to the bone in the last recession, Bohlin thinks businesses will continue to boost their capital budgets to maintain their competitive positions. "Corporations are going to have to ramp up just to stand still," he says.
    But the demands on management are changing. After years of cleaning up their debt and improving their credit ratings, many companies are starting to feel the need to satisfy stockholders more than bondholders, Bohlin notes.
    That means that the long end of the yield curve is not the place to be at present. Traditionally, ten-year Treasuries have yielded about 3.0% above inflation, but if that were the case today, they'd be at 5.0%, not 4.4%. "Right now you get paid 46 points to extend your maturities from two years to 30 years," says Martin, who is assiduously avoiding long-term bonds. Like Bohlin, he is convinced dividend-paying stocks with the ability to boost dividends are more attractive than bonds, even in an environment of price-earnings multiple compression.
    Over the next six months, two developments are likely to influence the bond market: the reintroduction of 30-year Treasury bonds and the replacement of Alan Greenspan at the Fed's helm. The increased supply of long-term bonds may provide a badly needed lift to long-term rates.
    Davison thinks that if Greenspan's successor isn't Council of Economic Advisors Chairman Ben S. Bernanke or someone else who is as transparent as Greenspan, the bond market will become more volatile in the short term. And as the economy gains momentum, yields on the ten-year Treasury could approach 5.5% by 2007.