The Big Bet on Lower Interest Rates

When investors believe interest rates will fall, they usually flock to either bonds or utility stocks. While I wrote about and called a new rally in the U.S. bond market roughly three months ago, U.S. investors are betting the Fed has stopped raising interest rates and that lower rates lie ahead.

The Dow Jones U.S. Utility Index started rising at the end of May 2006 and now sits close to its 52-week price high. Investors buy stable and predictable utility stocks when they believe interest rates will rise because the dividends utility stocks pay become more valuable in the market place as interest rates fall. Right now, the bet on U.S. utility stocks is big–big that the Fed will soon start to lower interest rates.

Two more thoughts we should consider before going with the “flow” of what other investors are predicting:

I’ve read a few reports lately from analysts that forecast interest rates in the U.S. will have to actually rise more to combat rising inflation. I just don’t see it. I’ve never seen inflation go up when housing prices are coming down. Thanks to China, the costs of many goods we import are getting cheaper, not more expensive. I don’t buy the “inflation is coming” view; hence, I don’t see inflation pushing interest rates higher.

Secondly, I’m usually uncomfortable following the herd mentality. If most investors believe interest rates will fall, and the prices of U.S. utility stocks and U.S. bonds are rising because of that belief, the general consensus is that interest rates will fall. Doesn’t the market usually do the opposite of what investors expect? Yes, it does. But in this case, we can see the damage 17 interest rate hikes have caused the economy and how further interest rate hikes might actually cripple the economy. Thus, I believe it’s safe to go with the consensus this time.

The worst kept big bet in the investment world is that interest rates will fall over the coming months. It’s a bet I’d have to agree with.