Sunday, January 22, 2006

2006 Bond Market Forecast

Here is my best estimate for the course of short and long term interest rates over the next year. It is based on techniques inspired by George Lindsay's stock market techniques. This year's forecast is really just a modification of what I said last year about 2006, so you should take a look at my 2005 Bond Market Forecast for a more detailed explanation of my approach.

Here are the last three paragraphs of my 2005 bond market forecast:

"Putting these observations together we make the following deductions. First the drop in yields from the May 2004 highs is not yet complete and will probably continue until August 2005. This date is 18 months after May 2004 and is as close as we can get to the yield lows predicted by the 10 year pattern (January and April 2006) without violating the range of historical experience for the 14 year period.

"From the predicted yield low in August 2005 yields will move up for about 15 months (the average duration during the declining phase of the 60 year cycle) until November 2006. We prefer this to the March 2007 date given by the 10 year pattern because the high in short rates (predicted for January 2007) typically follows the high in 10 year yields during the falling part of the 60 year cycle.

"How low will the 10 year yield be at the projected August 2005 yield low? We do NOT expect the notes to drop in 2005 below the 3.07% low yield reached in June 2003. Instead we think the 10 year notes will drop to about 3.60% by August 2005 and then rally to 5.20% by November 2006.From projected yield highs in late 2006 or early 2007 all the interest rate markets should move towards lower yields for about two or three years. That drop in yields should carry the 10 year notes below 3.00% and end the declining phase of the 60 year interest rate cycle that started in 1981."

The actual low yield in the 10 year note during 2005 occurred on June 3 at 3.80%, a couple of months earlier and 20 basis points higher than predicted. The treasury markets are now all in a trend towards higher rates.

I still think the 10 year note yield will make it up to the 5.20% level as indicated on the monthly chart above this post. However, since upmoves in yield typically last an average of 13 months, I would guess that the yield high will probably occur a little earlier than I predicted in my 2005 forecast, say August-September of 2006 as opposed to the November top I predicted in last year's forecast.

I think the top in the 3-month Treasury bill yield will be at the 4.95% level, a tad higher than I predicted last year, and will occur sometime during the last quarter of 2006.

Finally, I want to note that the 10 year cycle suggests we attend to market action during 1996 and 1986 for clues about this year's trend. Both years saw important low points in yield: January of 1996 and April of 1986. Given the current bullishness on the part of bond traders (which I noted here) I conclude that these two precedents are telling us to prepare for a big break in prices and a rally in yields during the first half of 2006.

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