2010 Outlook for Interest Rates

“Profit Confidential” Column, by Michael Lombardi, CFP, MBA

Each year at this time, I start a series of columns on my economic predictions for the year ahead. The 2010 outlooks for interest rates, the economy, the stock market, real estate, and precious metals are the five areas I will be forecasting on. Today, I start with interest rates.

To get a good handle on where the economy, the stock market, and real estate are headed in 2010, we first need to get a handle on where interest rates are going.

What we all know: interest rates are at their lowest levels in years. Why? In an effort to save the economy from the Great Depression, Part II, the Federal Reserve slashed interest rates in 2009 to a Federal Funds Rate of zero.

Advertisement

In the past, interest rates have gone up to cool the economy, support the weak dollar or to curb rising inflation. Right now, there is no economy to cool. The official unemployment rate in the U.S. is around 10%; the unofficial much higher. Business is still very soft for many enterprises. The problem is our dollar and the problem could become inflation.

As I have been writing, at some point ahead, foreigners are going to demand more from the U.S., if we want foreigners to continue buying the bonds we sell to finance our debt. The rate of interest bonds pay, in relation to their risk, is the single biggest factor for any bond-buyer in their evaluation of buying a bond. Hence, unless we see some stability in our dollar against other major currencies (which I doubt will happen), interest rates will need to eventually move higher to support the U.S. dollar.

Next, I believe inflation can become a big problem. There are too many dollars around as it stands. Give me a country that has not experienced rapid inflation when its national debt has gotten of hand and its currency started to devaluate. (See more inflation risk below.)

One year from today, I believe we will be sitting with interest rates higher than they are today. Interest rates could move higher as early as this spring, but more likely by the summer of 2010.

If our dollar starts to plummet in value against other world currencies, or if sudden bursts of economic activity appear, interest rates will obviously move higher, quicker. Otherwise, we could only be looking at a Federal Funds Rate of about one percent to 1.5% one year from today.

Michael’s Personal Notes:

Most of the time, I’m a big fan of Ben Bernanke. But I’m having a problem with his view on inflation. Bloomberg.com ran a story last week about Bernanke, the Fed Chairman, saying that Bernanke believes inflation will remain low. The story said that Bernanke believes a high U.S. unemployment rate and a low level of manufacturing capacity will keep inflation in check.

I’m on the opposite end. Historically, when interest rates have fallen dramatically and when the monetary policy is so expansive, inflation has always followed. In my lifetime, I do not remember a time when interest rates stayed so low for so long. Hence, we are dealing with the unknown going forward, as to how prices will follow a prolonged period of extremely generous monetary stimulus.

There is also the risk of dollar devaluation. It is no secret that the U.S. dollar has been moving lower for the past three years against other major currencies. Historically, currency devaluation leads to inflation.

Inflation can be a much bigger threat going forward than what many analysts and economists expect.

Where the Market Stands:

As I write this column early this morning, stock futures are pushing higher. While the Dow Jones Industrial Average sits 17.7% higher today than it did at the beginning of the year, my gut tells me that the market wants to finish the year even higher.

Let’s face it; 2008 was a terrible year for stocks. And, by the spring of 2009, most investors had bailed out of stocks. The holiday season is here. All those investors that did get out of stocks in 2009 (and took losses) are looking back now and saying two things: “What a mistake” and “Looks like the economy is doing better than we all expected.” This is the kind of thinking a bear market loves to spread. And that’s why I believe we are headed higher with stocks before the big turn back down.

What He Said:

“Recipe for Catastrophe: To me, the accelerated rate at which American consumers are spending, coupled with the drastic decline in the amount of their savings, is a recipe for a financial catastrophe.” Michael Lombardi in PROFIT CONFIDENTIAL, September 7, 2005. Michael started talking about and predicting the financial catastrophe we started experiencing in 2008 long before anyone else.