RBC Capital Markets has lowered its forecast for U.S. interest rates and yields, owing to a cloudier economic picture.

“Our house forecast for U.S. rates and yields remains bearish, but not as bearish as it was,” it says in a new report, noting that it has revised down its projection for the Fed funds rate to 3.5% at the end 2005 from its previous forecast of 4%.

“We continue to look for a peak in bond yields around mid-2005,” it says, but it now expects 10-year yields to peak at 4.95% rather than the 5.50% it was expecting. It has also lowered expectations for two-year bonds to 4% from 4.40%.

“Our forecast changes reflect the lower base from which we see the bearish trend emerging following the Q3 rally in bonds, a more benign inflation background than we had anticipated, although we still see inflation rising over the next six months, and greater uncertainty over the sustainability of the global recovery through 2005,” it says.

The rest of the bond market is even more skeptical of the Fed’s intentions, notes National Bank Financial. “After three Fed rate rises, the bond market is betting against the manifest intentions of the central bank,” it says.

“The market anticipates only four more quarter-point rises in the fed funds rate in 10 FOMC meetings between now and the end of 2005,” that would only bring the fed funds rate to 2.75%. But, NBF notes, Fed officials put the equilibrium rate in the 3%-5% range. “ Bond traders may come to regret betting against the Fed,” it warns.