What Stable Rates Mean For The Bond Market Rally

U.S. Treasury yields have not risen higher since the Fed announced the end of quantitative easing a week ago. The yields on the 10-year note are 2.33 percent, the same as they were when the asset purchase program ended.

The yield on the 10-year note began the year at 2.96 percent. So, what is this year's bond market rally forecasting when it comes to long-term rates next year?

Looking Ahead

Most economists and policy makers expect the Fed to raise the Fed Funds rate in the middle of 2015. This is a very short -term rate, in fact, it represents the interest rate banks charge each other for just a one-day loan. The rate has been near zero since 2008, and the Federal Reserve controls it.

Market participants control long-term rates, those tied to bonds and loans whose maturity are longer than five years. These bond-buyers include other Central Banks, large commercial banks, hedge funds and individual investors.

Related Link: QE Is Over; Bull Bond Market Likely Isn't

Long-term rates respond to inflation and inflation expectations. Once tapering began late last year, most investors expected rates to rise. They have not because there is only a very small amount of inflation currently in the U.S. economy. Inflation next year is also forecasted to remain low.

The rally in the bond market this year signals that in the global economy, wage and price inflation will remain light for a considerable period.

What Are The Reasons?

Despite higher employment, wages are not going up. Recently, oil has fallen to multi-year lows. Housing prices have not risen substantially this year and some commodity prices are falling.

In addition, two other major central banks, the ECB and BOJ, have both recently embarked on aggressive bond market intervention aimed at lowering interest rates in their regions. While the Fed is moving out of the U.S. market, other central banks are moving into their own markets to keep interest rates extremely low. In Japan the 10-year note yields only 0.46 percent; in Germany it is 0.85 percent.

What's This Mean For The Fixed Income Investment Decision?

The Fed will most likely raise short-term interest rates by next July, but that does not mean investors should lower their allocation of bonds. Not all rates will move higher.

Long-term rates will remain where there are now or possibly move lower. Rates will rise on bonds that mature in five years or less; the result of this is a flattening yield cure.

For fixed income investors, the rotation should not be out of bonds and into equities, real estate, or commodities when the Fed begins hiking rates. Instead, bond buyers should maintain their allocation but move into higher credit rated/less risky bonds. Holdings in junk bonds and low-rated municipal bonds should be reduced and high grade corporate, municipal and Treasury bonds be increased.

Assuming the Federal Reserve hikes the Fed Funds rate next year, it will not signal the beginning of a bear market in investment grade bonds or ETFs. On the contrary, the long-term bond market is expected to hold on to its gain and is poised to yield stable returns for many quarters.