Don’t Bother Trying to Predict Interest Rates

Are low interest rates on your savings account or bonds driving you crazy yet? Well, perhaps my prediction will cheer you up:

If interest rates rise sharply—something bound to happen in the future, since they can’t go any lower than they are now…

Good news, right? Unfortunately, I made this prediction in February 2010, and I was completely wrong.

But I’m just some guy. What if we asked professional economic forecasters, people whose job it is to, y’know, make economic forecasts?

Well, two years ago, in July 2009, the Wall Street Journal asked fifty forecasters whether the interest rate on the benchmark 10-year treasury note would be higher or lower a year later, in July 2010.

If you were to sum up the forecasters’ sentiment at the time, it would be, “Interest rates can’t go any lower than they are now.” Forty-three of them predicted higher rates. Five predicted slightly lower or static rates. Two out of fifty predicted much lower rates.

You already know how that turned out: rates went much lower, from about 3.5% to 2.95%.

Surely, forecasters got smarter after that, though, right? Bill Gross is generally considered the world’s greatest bond trader, and he’s in charge of the world’s biggest bond fund, PIMCO Total Return (PTTRX). In February, Gross sold all of his fund’s treasury bonds, warning that interest rates couldn’t go much lower. The 10-year T-note was once again yielding about 3.5%. In June, with yields at about 3%, he stepped up the rhetoric, warning that treasury investors would “get cooked like frogs in an increasingly hot pot of water.”

So how did that work out? Two weeks ago, the Wall Street Journal reported:

“In recent weeks, Pacific Investment Management Co. founder Bill Gross says he has ‘lost sleep’ over an ill-timed bet on Treasurys.”

The current 10-year rate: 1.98%.

This is starting to sound like a slapstick comedy – like Caddyshack with interest rates instead of the gopher. Let’s check in with the WSJ’s favorite economic forecasters: According to the August 2011 survey, the consensus is that 10-year rates will climb to 3.5% by December 2012.

Here is the take home message for you…

Don’t bet on it

No matter what anyone says, interest rates can still go much lower. That doesn’t mean they will. Nobody can predict interest rates. Not economists, not bond fund wizards, and certainly not you and me. If you’re doing anything with your money based on an assumption about future interest rates—such as shifting your bond portfolio to cash while waiting for bonds to return to “normal” rates—you’re gambling, plain and simple (the same goes for waiting for the stock market to return to normal, but that’s another story.)

Mike Piper of the Oblivious Investor blog made that mistake: he shifted to short-term bonds, figuring interest rates had to rise. But he was big enough to admit it, eloquently:

It’s easy to make observations about current market conditions (e.g., ‘by historical standards, interest rates are unusually high/low’ or ‘by historical standards, stocks are expensive/cheap’). But interest rates can stay low (or high) and stocks can stay cheap (or expensive) for a very long time. And unless we can predict when things will change, it’s difficult to draw much benefit from such observations.

You know what I want? I want to buy a long-term inflation-protected bond paying a real rate of 3.5%. I also want a pony with a silver saddle. I hate low interest rates as much as the next guy, but there’s almost nothing I can do about it.

I say “almost” because there are a couple of ways to beat zero interest, modestly:

Save more. Sorry. Had to say it.

Consider certificates of deposit. According to DepositAccounts.com, the best 5-year CD pays 2.73% interest. A 5-year treasury bond pays 0.88%. They’re equally safe. This is like choosing between the same iPod selling for $100 or $300. Take your pick. Most banks let you hold CDs in an IRA.

Don’t forget savings bonds. Series I savings bonds, which track inflation, are currently paying 4.6% for the next six months, and an undetermined rate after that. You can cash them in anytime after the first year. You can buy up to $10,000 in I bonds this year ($5000 electronic and $5000 paper); that’s expected to drop to $5000 next year when paper bonds are discontinued.

And remember the most important lesson of all: When interest rates are low, it’s easy to get talked into something with a little more yield and, supposedly, no more risk. But anything that pays more than a CD or I bond is probably risky. If it doesn’t look risky, that’s even worse: it’s risky in a way that will kick you like an angry pony when you least expect it. Remember Schwab’s YieldPlus fund (SWYSX)? It was like a money market fund, only with a higher interest rate.

That’s an actual chart in the link. It also looks like what happens to my brain when I try to predict interest rates.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.