Biggest Treasury Bear Still Sees Fed in Control

NEW YORK ( TheStreet) -- His call for 10-year U.S. Treasury yields to hit 3.76% by year-end makes him the most bearish bond forecaster in a Bloomberg survey of 71 market economists, but even Parsec Financial chief economist Jim Smith sees the Federal Reserve largely in control of long-term interest rates.

I called Smith because I was looking for someone to tell me a scary story about an imminent spike in long-term interest rates, but he doesn't sound especially alarmed. In fact, after I spoke with him last week, he lowered his forecast from 4.11% to the current 3.76%.

Smith explained that his forecast is based largely on studies that have shown "long-term interest rates in most developed countries typically are about 300 basis points 3% above anticipated long-term inflation. If you anticipate we might be in for low inflation over the long term of around 1% then 'normal' 10-year Treasury rates ought to be around 4%," he says.

Still, Smith finds it difficult if not impossible to imagine interest rates could rise from their current levels to even as high as 4% in a period of a few days. My original question to him was whether he could see them jumping from current levels to 6%.

"For that to happen you'd have to have an earthquake devastate Hawaii and start moving toward California," he said.

I didn't understand why a simple market panic wouldn't do the trick. As this popular skit explains, markets are all about sentiment, so if sentiment can cause a stock market crash in a single day, why can't bond markets do the same thing?

"It's certainly possible," Smith acknowledges, "but never -- whats the Wall Street saying? 'Never fight the Fed.' They can stop that kind of panic in its tracks," he says.

This from the most bearish of 71 Treasury forecasters.

And still, everyone from Berkshire Hathaway Chairman Warren Buffett to former Fed Governor Frederic Mishkin has warned of a massive bubble in U.S. Treasuries. Hedge fund managers such as David Einhorn and Stanley Druckenmiller have warned about a Treasury bubble as well, according to a recent article by ProPublica's Jesse Eisinger, though I could find no evidence of this. Certainly those hedge fund managers have been sharply critical of the Fed's easy money policies, but I didn't see them warning about a bond bubble. Maybe they did.

Regardless, others clearly do. Deutsche Bank economist Peter Hooper and Morgan Stanley counterpart David Greenlaw co-authored a paper in February with Mishkin and University of California San Diego professor James Hamilton warning of a potential "tipping point in which sovereign interest rates shoot up and a funding crisis ensues." Nonetheless, the official Bloomberg forecasts from their colleagues at Morgan Stanley and Deutsche Bank call for 10-year Treasuries to finish the year more or less where they are now.

What are we to make of this? I'd say it largely shows that if you push a market economist -- even 71 of them at once -- and ask them where the market is headed over a six-month period, they'll give you a number that isn't far from where it is today. They don't want to stick their necks out. They like their jobs, and they'd rather play it safe. They'll probably be right, and if they're wrong, they'll be wrong with everyone else, so no big deal.

Look at page five of this consensus survey of economists in April 2011. Asked where 10-year Treasuries would be by the end of July that same year, they said 3.6%. In fact, 10-year Treasuries finished July 2011 at 2.82% Asked where they'd be at the end of April in 2012 -- a year from the time of their forecasts -- and they said 4.6%. Instead, yields moved lower still -- to 1.95%.

Judging from today's forecasts then, and from my interview with the most bearish member of the group, one could be forgiven for concluding 71 economists think the Fed is in control of long-term interest rates. The Fed maintains this control despite the fact that it will have to exit an unprecedented $85 billion a month of stimulus it is providing by buying Treasury and mortgage-backed securities. Surely 71 economists can't all be wrong. Unless they are.

-- Written by Dan Freed in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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