This time last year I wrote about my expectation for long-term interest rates to start moving higher during 2004. I got it only half right. They moved higher during the first half, but then fell back during the second half. It looks like bond yields will end the year pretty much where they started. A number of readers have asked why bond yields have stayed so low for so long and for my outlook for next year. Chart 1 shows bond yields turning back down at the start of 2000 and bottoming in mid-2003. The 2000 peak in yields coincided a falling stock market and rising bond prices. The deflation threat that existed at that time caused a major decoupling of bond and stock prices. As a result, bond yields and stocks became positively correlated. Bond yields turned up shortly after stocks during the first half of 2003, right after the start of the Iraq war and a plunge in oil prices. That caused a major rotation out of bonds and back into stocks -- reversing the 2000-2002 bear market trend. Chart 1 shows the yield on the Ten-year Treasury note turning up during the first half of this year and breaking the four-year down trendline (see circle). That wasn't a surprise. What was a surprise was the subsequent decline in yields back to that same trendline (see arrow). Let's take a closer look.
