Further Rate Drops May Not Be Good


While world stock markets tumbled this week over new worries about Asia, investors should have been cheering one of the few factors that went their way: a sharp decline in interest rates and bond yields.

After all, such a decline is great for home buyers, consumers and businesses, lowering rates on mortgages and other loans while propping up corporate profits.

But many analysts doubt rates will fall much further, making bonds a risky bet for investors jumping in now in hopes of profiting from falling yields. And even if yields do fall further, it could reflect such a worsening of the world economy that U.S. stock prices might sink--a reversal of the normal relationship that has stocks rising when interest rates fall.

Interest rates are once again touching historic lows, thanks to the near-absence of inflation and the rush by foreign investors to load up on U.S. Treasury bonds. The yield on the benchmark 30-year Treasury bond finished Friday at 5.66%, up a hair from Thursday when it hit its lowest level since regular sales of the securities began 21 years ago.

Normally, world stock markets rally in a week featuring both record-low bond yields and comments from a Federal Reserve Board chief hinting that he won't raise interest rates.

But the Dow Jones industrial average sold off deeply Thursday and early Friday, and foreign markets fared far worse. The Dow recovered late Friday to close up modestly, but it looked more like a "relief" rally than a glimpse of more gains to come.

Bond yields might ease a bit more in the next couple of weeks as anxiety about Asia remains high, experts say. But after rallying to their best weekly performance in more than two months, yields are unlikely to dip significantly without unmistakable evidence that global troubles are worsening, many analysts say.

"The Treasury market has benefited from all these problems around the world, and to do better, we'd need to see some more," said Michael Cloherty, a bond-market strategist at Credit Suisse First Boston in New York.

But if global economies were to slide so much as to cause rates to tumble, U.S. investors would then have to face up to a new set of worries.

If rates fall, "it would be a reflection of worsening economic conditions in Asia, leading perhaps to a global recession," said Sung Won Sohn, chief economist at Norwest Corp. in Minneapolis.

U.S. bond yields have fallen in recent years for positive reasons such as low inflation and a government budget surplus, Sohn said. But if they are driven down by Asian currency devaluations or a worldwide recession, the U.S. stock market would be hit hard regardless of what interest rates do, he said.

Low rates, of course, have stoked the U.S. economy to this point. With inflation in check, falling rates have fueled the stock and housing markets. Low rates might spark another mortgage refinancing surge, though it probably would not be as frenzied as the boom earlier this year because many homeowners already have acted.

Falling bond yields also ease the pressure on stocks by relieving some fear about potential damage to corporate profits from Asia's morass.

As for Asia itself, Federal Reserve Board Chairman Alan Greenspan's comments Wednesday suggesting that he would not raise short-term interest rates were positive. Any sign of a Fed hike could exacerbate the region's credit crunch and staunch foreign investment.

The direction of interest rates is of immediate concern to U.S. investors, who profit when bond yields fall because their higher-yielding securities are worth more. When bond yields fall, bond prices rise.

The mutual fund industry's main trade group estimates that investors stashed $7.5 billion in bond funds last month, up 70% from April's $4.4 billion, while cutting their contributions to stock funds.

That movement to safety could be a wise move if the equity markets gyrate. But investors also should realize that if Asia appears to stabilize and rates move back up even a little bit, as happened earlier this year, they could lose some money.

Rates bottomed at 5.69% on Jan. 12. But as Asia fears subsided and the U.S. economy kept chugging along, rates jumped back over 6% three times in the next five months.

The average long-term government bond fund had a year-to-date total return of 3.48% through June 5, according to Morningstar Inc. But from Jan. 12 through April 29, when they hit their recent high of 6.08%, those funds lost 2.10%. Investors still received their regular interest payments. But the capital loss from rising interest rates more than wiped out their gains.

Few observers expect interest rates to move dramatically either up or down in the short-term. Still, a moderate pick-up in rates could leave investors with nagging losses.

If an investor buys a 10-year Treasury bond today and rates rise by 0.25 percentage point, he or she would face a loss of 1.8 percentage points in overall return, said Casey Colton, a bond-fund manager at the American Century mutual fund family. Someone buying a 30-year Treasury bond would have a 3.25-percentage point loss.


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Bouncing Bond Yield

The yield on the 30-year Treasury bond reached a new low this week, undercutting its level of earlier this year. At that time, the yield bottomed in January but jumped back above 6% three times in the next five months:

Friday close: 5.66%

Source: Bloomberg News

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