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Prognosticating Interest Rates

November 8, 2016

A previous blog gave a self-assessment method to determine where you feel the stock market and the level of dividends would be in 10 years. However, in some respects the bond market might be more important to the many investors that primarily buy bank certificates of deposit, bond funds and other fixed income securities. These investors are very risk adverse and likely buy the CDs, bond funds and bonds because they are primarily concerned with the cash flow and safety of principal.

Now I ask you to apply the stock market predicting process to bank CD interest rates and inflation, and if a bond owner, to bond rates. Set up three more graph sheets. Draw a line to indicate where you believe the CD interest rates will be over the next ten years. If you usually buy 1-year or 2-year or even 5-year CDs, put down the ten years trend of what you think those rates will be. On the next two sheets mark off the next ten years annual inflation rates; and long term bond rates.

CD and bond interest rates
If your trend is up it might possibly suggest you should keep your fixed income allocation in short term vehicles waiting for the increase. In today’s market I do not believe you have any other course. Right now the highest short term rates seem to be about 1.25% for a 15 or 18 month CD. Longer term CDs aren’t paying much more – at best 1.75% for a 5 year CD. If you are in individual corporate bonds, you can probably do a little better if you go for less than the top rated bonds and need to go out 10 years to get about 1% higher or 2.75%. 20 year corporate bonds are around 4% to 4.25%. If you typically buy bond funds you should understand that as rates increase the fund values will drop and this will reduce your “total return” on the funds. Because of this I do not believe owning bond funds are a viable investment strategy. My advice for those with CDs for now is to get the 18 month CDs. If you like bond funds I suggest you read my prior blogs – look at the archives on the right for them. If these don’t change your mind, then you deserve the consequences.

If your trend is down you should lock in some longer term rates. Go for the five year CDs or ten or twenty year bonds. If you believe the rates will go lower then you might also believe we will not have much inflation – see next comments.

Inflation
If your trend is up it shows you believe we will have increasing inflation. How much depends on the slope of your line. If you are right then interest rates should rise. So your strategy should be to keep your money in cash waiting for rates to rise. Opps, here is the “waiting” word – see what I wrote above and some previous blogs. You might also want to buy some TIPS or I-Bonds. If your trend is down this would suggest that you feel we are headed for deflation which accompanies a recession or depression. In this case you should lock up your money in safe insured CDs or U.S. Treasury Bonds. And I would certainly stay away from equities.

Inflation and interest rates
These are tied together. Inflation brings higher rates and low inflation such as we’ve had for the last few years brings low rates and in some cases a flight to safety with negative rates that exist in some countries.

Your graphs
These exercises force you to think about what is going on and to make decisions. I believe the more people understand the more involved they will be in the investing process, and that helps toward making them more secure.

Diversification
A key to investing is having a sense of which way there will be movement in the stock market, interest rates and inflation. However, these are at best your guesses and it is unlikely that you will be right about everything and certainly the timing of the activity. Accordingly, regardless of what you think, you cannot go all in one way – you need diversification and that will come with a sensible thought out asset allocation plan that matches your investments with your goals.

Whatever, you decide, good luck!

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