If you have been following the economic fundamentals over the past year, you have been worried about higher long-term interest rates. Unemployment is at a 5-year low; GDP and CPI, year over year, are high; the operating capacity of US manufacturers is near 82%; and the stock market is on a run. According to my regression model, the current confluence of economic data is consistent with 30-year Treasury bond yields near 5.9% -- approximately a 3% premium over the Core CPI. So what is the rationale for 30-year Treasury yields at 4.6%? The answer can be defined in three words: inverse yield curve. An inverse yield curve is when short-term interest rates are higher than long term interest rates. At a very basic level, an inverse yield curve is the bond market betting that the trend of long-term inflation will be less than the current rate. For an inverse yield curve to be correct, the forces of inflation must be diminishing. That can only come through a slowing of the economy. I have long thought that long-term bond traders are the most accurate readers of the economic tea leaves. With 30-year Treasuries yielding 4.6% and overnight Fed Funds trading at 5.25%, the bond traders are clearly saying--betting-- that inflation will fall. Indeed, according to my models, a 4.6% long-term bond yield implies that Core CPI would need to fall to under 2% during the coming 12 months to be in equilibrium with its normal yield spreads. Therein lies the proverbial rub. Core CPI is now at 2.9%, and since Core CPI does not include food and energy, it will get little help from falling energy prices. There are two paths to a Core CPI under 2%: 1. A sharp slowing of the economy that might result in a recession, and 2. A protracted period of sub 3% GDP (driven by weak housing), perhaps lasting for 12 months or more. The long and short of the present level of interest rates is that the economy will be tepid for the next 12 months. This will almost certainly dampen corporate profits during this time. With corporate earnings growth having blown away estimates quarter after quarter this past year, I believe the market is being set up for disappointments in the year ahead. Having said this, as I have been repeating, I believe the disappointments will be mainly in the small and mid cap sectors whose businesses are tied primarily to the US domestic economy. Blue chips, which are much more international in scope, will be only modestly affected by the slowing US economy, and will increasingly be seen as the place to be by investors. Bond buyers have a very difficult decision. Do you keep rolling over the higher yielding short-term bonds or do you extend your maturities and take a lesser yield, in the hopes that the bond traders are right and both short and long-term interest rates will be lower in 12 months? I think you can guess my answer -- don't bet against the long-term bond traders. This blog is for information purposes only. Do not make buy and sell decisions based on the information contained here. Please consult your own financial advisor.