Against the grain

Searching for clues about the direction of interest rates? Read on and ponder.

The chart below illustrates net cash flows for all government bond mutual funds over the last five years. Net cash flows are total purchases minus total redemptions. As you can see, the third quarter of 1997 was the first quarter in over three years where more shares of bond funds were purchased than sold. Is the trend your friend?

If you match up the direction of interest rates over the last five years with the net cash flows, the trend is your friend-in reverse. For example, over $22 billion was liquidated during 1994, just as the two-year Treasury Note was peaking at 7.75%. You may remember this period of rapidly falling bond prices that was triggered by a Federal Reserve Bank policy change and led to the Orange County California bankruptcy filing, among other disasters.

Conversely, the greatest net inflows occurred in 1992 just prior to the most recent low point in bond yields in April of 1993. It appears that these cash flows are a good contraindicator of the direction of interest rates. When cash flows peak, interest rates change direction.

Most bond fund investors are individuals and it looks like they panic by selling when interest rates rise and their market values fall. This is the best time to buy, not sell.

When interest rates fall, yields on bond funds do not fall as fast as individual issues due to the fact that bond funds contain many issues which do not all mature at once. This lag effect makes them popular for yield buyers, which individual investors tend to be.

Banks face the same trap due to the loan demand cycle as investable funds are usually channeled to the loan portfolio when bond yields are most attractive. When the economy slows, you always have too much to invest at the wrong time. If you want above average performance, you must be willing to invest against the grain.

In conclusion, the bond fund numbers suggest that interest rates may trend lower in the months ahead. This information is only one clue in a complex puzzle, but when you see the inflows peak, watch for a change in the market. Keep in mind that the overall goal in developing an educated guess about rates is to be vaguely right rather than precisely wrong.

[Author Affiliation]

Jeff Goble is executive vice president in the investment banking division at UMB Bank, n.a., Kansas City