Investors who heeded the forecasts of Merrill Lynch & Co, Lehman Brothers Inc and other Wall Street firms in recent months may be missing the biggest rally in two-year US Treasury notes in six years.
Two-year notes have returned 5.2 percent for investors who held them since the beginning of the year. Prices surged as the Federal Reserve cut overnight bank loan rates seven times, driving yields to a record low of 3.63 percent last week.
Almost three quarters of the 25 economists polled by Bloomberg in December said the securities would fall, boosting their yields. The median forecast showed yields rising to 5.3 percent by the end of September.
"Economists are like weathermen," said Steven Bohlin, who helps manage US$1.8 billion at Thornburg Investment Management in Santa Fe, New Mexico. "They think that they have a system that predicts trends, but the historical evidence of that is weak." Many economists are sticking by forecasts calling for an economic recovery that might convince central bankers to stop lowering interest rates. That may mean the rally in two-year notes is coming to an end.
Twenty-four of the 35 economists in the latest Bloomberg poll, conducted two months ago, said the two-year note rally would fizzle in the third quarter, leaving yields anywhere from 4 percent to 4.8 percent at the end of September. Yields since the poll was taken have dropped almost half a percentage point, to 3.76 percent.
Gary Thayer, chief economist at St. Louis-based A.G. Edwards & Sons and the most bearish in the June survey, said he still anticipates an economic rebound.
Tax rebates and Fed rate cuts are taking longer to jumpstart growth than he expected months ago, he said. "This is not a classic recession, where every part of the economy gets hurt."
Thayer points to the index of leading economic indicators, noting that the gauge of future business activity rose for a fourth month in July. He sees economic growth rebounding to 2.5 percent this quarter from its 0.7 percent pace in the second quarter.
Edward McKelvey, a Goldman, Sachs & Co economist, said he was surprised investors stopped fretting about a pick-up in inflation during the last two months.
In May, "the market was concerned about inflation and wouldn't let go," said McKelvey, who estimated two-year note yields would wind up at 4.1 percent this quarter.
A perception the Fed might cut interest rates enough to heat the economy up, spurring inflation, weighed on 30-year bonds in the two weeks leading up to May 15, when the central bank reduced interest rates for the fifth time this year.
Yields on bonds, among the securities most vulnerable to inflation, rose 27 basis points to 5.91 percent.
Bonds have rallied since then, lowering yields to 5.45 percent, thanks in part to Fed Chairman Alan Greenspan's assurances that inflation will be contained.
Yield forecasting, to be fair, can be tricky, given the countless conditions that affect the bond market.
"We're trying to apply a consistent strategy, but this year has been a challenge," said Thayer at AG Edwards.
Some projections for where note yields will be on Sept. 28, the quarter's last trading day, seem on target.
Orawin Velz of Fannie Mae, the government-sponsored company that buys mortgages and turns them into securities, in June said two-year notes would finish the quarter at 3.7 percent. She'll be right if notes hold steady in the next five weeks.
Brian Wesbury, chief economist at Griffin Kubik Stephens & Thompson in Chicago, will look like a seer if two-year notes give up some of their gains by the end of next month. He forecast a yield of 3.9 percent.
Predicting interest rates is like baseball, Wesbury said. "A batter is great if he hits three out of 10. I'd say a forecaster is pretty good if he gets six out of 10."
That's why many investors don't even try to make their own long-range rate projections.
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