Up or Down? Interest Rate Outlook Could Be Either or Both: The Fiscal Cliff, Political Gridlock, European Sovereign Debt Crisis and Other Global Economic Scenarios Make It Hard for Traders and Analysts to Agree on What Will Happen in Fixed Income Markets in the Next Six Months

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Interest rates are going up, say some traders, fund managers and analysts. But others say they'll be going down. Just like the outlook for maintenance of the U.S. Federal Reserve's freezing of short-term interest rates through mid-2015, the yields and pricing of interest rate futures will be subject to many dynamic forces in the next few months.

The presidential and Congressional elections are now behind us, but with the U.S. fiscal cliff, Europe's sovereign debt problems and challenging economic conditions both domestically and around the world unresolved, volatility will be the watchword going forward.

The dynamic forces are driving some traders and analysts to the view that the more than 30-year bull trend in fixed income may be over soon.

"Our current view on interest rates is bearish based on some recent improvement in our macroeconomic measures coupled with an overvalued U.S.

Treasury market," says Joseph A. Baggett, founder, chief investment officer and portfolio manager for Dix Hills Partners.

Baggett says his company's research has concluded, and recent experience shows, that neither current non-traditional zero interest rate policies (ZIRP) nor quantitative easing (QE) guarantee a "straight, smooth path" to perpetually lower interest rates.

"Rather, we would argue that rates will fluctuate over time to reflect changes in market participants' expectations for the duration and magnitude of QE/ZIRP," Baggett says. These changes in expectations will be driven by evolving economic conditions in terms of both real growth and inflation, he adds.

Baggett notes that on a month-to-month basis throughout the Treasuries' bull trend, interest rates actually have risen 47% of the time from 1981 to the present (see "Ups & downs," right). "[You] need to be flexible and opportunistic when it comes to interest rate forecasting," he adds.

Baggett also notes that real rates are negative in Germany and the United Kingdom as well as in the United States (see "Keeping it real," right). "As such, our bias is for higher rates in those sovereigns as well," he says. He adds that Dix Hills also currently is short Japanese government bonds, but the position size and investment conviction is much smaller.

Baggett says "headline risk" of the European sovereign debt crisis seems to be diminishing slowly as markets react less violently to each new twist and turn in the saga. A positive baseline scenario for the European crisis likely would lead to improved confidence for Europe's investors and consumers, he adds. "As such, a potentially rebounding Europe in 2013 might bolster--not undermine--U.S. economic prospects, Baggett says. "Further, we feel that recent U.S. economic improvements can be sustained by reduced political uncertainty through the conclusion of the November elections and some progress on the 'fiscal cliff.'"

Larry McDonald, senior director for credit, sales and trading at Newedge, says that an unusual phenomenon for the last couple of years has been systemic risk, in that Europe has created a constant bid for Treasuries.

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"U.S. Treasury yields have been suppressed by global systemic risk," he says. "Now the horrifying thing is if Europe just normalizes and we go back to a 2003 to 2006 type of world where there really was no systemic risk, then you are going to see a 100-150 basis point increase in Treasuries because you just don't have that flight to quality."

Recently, he noted Treasuries have not been rallying during stock market sell-offs as they have in previous market corrections. "That is very, very, very unusual. This has not happened in the last two or three years. It either means that U.S. and global investors are relieved that the relaxation of systemic risk in Europe is starting to hurt the bid for Treasuries, or for the first time investors are starting to look at the fiscal cliff--not just the fiscal cliff but the deficit, the budget and Washington inaction--because Treasuries are not rallying the way they should be. …