(FORTUNE Magazine) – It's not the kind of event that makes the evening news. But a powerful, sustained drop in long-term U.S. interest rates is now under way, promising good things ahead for investors and for the economy. After topping 8% last November, long rates have tumbled below 7.5%, and many economists expect them to trend down further through next year. Some think rates could drop even more, perhaps falling into the 4% range, later in the decade.

If they're right, investors--perhaps you--can expect to make money buying bonds, which rise in price when interest rates fall. That will hold true even if you were among the hordes who fled from bond mutual funds last fall after rates soared and prices imploded--and just as the market bottomed. Moreover, if forecasts of continued falling rates are correct, the current economic expansion--already longer than the typical postwar upturn--will likely continue rolling along well into 1997.

The economic story that underlies this cheery outlook for interest rates over the next year is a simple one. Our tough-love hero, the Federal Reserve, has raised short-term rates enough to cool the economy, which in turn will keep inflation from getting out of hand. As expectations of future inflation recede, investors will be satisfied with lower bond yields. The consensus economic forecast, compiled by the newsletter Blue Chip Economic Indicators, envisions growth slowing from 4% last year to about 2% in 1996. It projects consumer inflation at a mild 3.5%.

Evidence that the Fed has engineered a slowdown is indeed mounting. Homebuilding and auto sales--businesses that are especially sensitive to interest rates--have clearly softened. Retail sales have slumped. Wages have yet to accelerate. Economist William T. Wilson of Comerica Bank in Detroit even has some good words for Mexico's financial debacle: Recession south of the border will help contain U.S. growth and thus price pressures. Comerica predicts that the yield on 30-year Treasury bonds will skid toward 6% next year. "There is no danger inflation will spike," says Wilson.

Professional bond investors started getting that message last November, as they noticed that the market's expectations of sharply higher inflation weren't confirmed by the broad gauges of inflation like the consumer price index. At the same time, the Fed delivered a powerful 0.75-point jump in short-term rates on November 15--the central-banking equivalent of banging your fist on the table--convincing more market participants of its inflation-fighting resolve. "The Fed regained credibility," says Brad Tank, a portfolio manager at Strong Capital Management. "Before that, people were convinced bond prices would go down forever, and the market got oversold."

Oversold is a very mild way to describe what happened last year. The total return from bonds in 1994 averaged -7.8%, making it the second-biggest bond debacle in 70 years, according to Ibbotson Associates, a Chicago financial consulting firm. (The worst year for bonds: 1967.)

Once the market's perception changed, however, some bondholders made a lot of money in a hurry. Just since mid-November, the total return on long-term bonds has exceeded 8%. Professionals and large investors, who mostly buy their bonds directly from the government and from dealers, cleaned up. Small investors, who get in and out of the market via mutual funds, tended to miss this rally, because they had panicked and fled prematurely. C'est la vie.

Even if you lost big last year, you shouldn't be curled in the fetal position today. Analysts who study the dynamics of the bond market think it has sufficient momentum to shrug off the occasional bad economic report. That's why bonds haven't flinched in the face of the plunging dollar, even though in theory the Fed might decide to raise interest rates to defend the currency. Nor did the market fall when the government in early March announced that employment was growing briskly, since the report also showed that wages were weak. Bonds rallied through a report of rising wholesale prices for crude and inter mediate materials, because the increases weren't percolating through to finished-goods prices. "The market is seeing real evidence of an economic slowdown now," says David Wyss, chief financial economist at DRI/McGraw-Hill, "so there are still some gains to come for bond buyers." DRI predicts economic growth will soon drop sharply to under a 2% rate, with long-term interest rates falling below 7% next year.

Visions of such a soft landing underpin the actions of many money managers, who aren't cashing out of bonds even though they've made big gains since November. T. Rowe Price managing director Peter Van Dyke says the firm's asset-allocation mutual funds will remain overweighted in bonds, a decision affecting $3.4 billion of assets. In the Personal Strategy Balanced Fund, for example, 38% of the assets are in bonds, vs. a typical 30%. Van Dyke likes the economic fundamentals--such as the Fed's monetary tightening and stable labor costs--but he also notes that mutual fund investors have just about stopped fleeing bond funds. Once they return, the market will get a lift. Budget cutting by the Republican vanguard in Congress could help too (see box).

What if the soft-landing scenario doesn't happen? If the economy is still really cooking and the Fed again begins a series of interest-rate hikes to prevent future inflation, bond prices could fall. In contrast, should it turn out that the Fed has already been too harsh--and a recession ensues--bonds will do well, since interest rates would go down.

Still, risk-averse money managers are wary about the interest-rate outlook over the next few months. "It's much less easy now than before the rally to say there is great value here," says Strong Capital Management's Brad Tank. "We'll be hitting some nasty bumps." Worries include upticks in the volatile monthly inflation numbers and a temporary revival of consumer spending once delayed IRS refunds get mailed out. Tank, nevertheless, is sticking to his 45% bond weighting, vs. a normal 40% position, in the $225 million Strong Asset Allocation Fund. T. Rowe Price's Van Dyke advises investors sitting on cash to put a third of it into bonds now, and see what happens. Matt Avery, manager of the $5 billion Franklin Income fund, is holding tight with his 57% bond allocation, up from 50% at the beginning of the year. "I'm not selling, but I wouldn't buy the long bond at 7.3%, either," says Avery. "If bonds weaken on some inflation report, say, and rates go above 7.5%, then I'd consider buying."

Other professionals already think it's time to trim the sails. Jeffrey Tyler of the Benham Capital Manager Fund is reducing his bond weighting to 35% from 42%. "The market is ignoring bad news and seizing on the good news," he observes. The drop in long rates will stimulate the economy, especially housing, disappointing investors betting on a slowdown, Tyler says. Bob Haber, who runs $9 billion in assets at Fidelity, the nation's largest mutual fund company, believes that better bond values are now to be found in foreign markets. In the domestic market, he says he has "dramatically" reduced average maturity, which would blunt losses if interest rates rise.

These caveats apply to the remainder of this year, and don't much worry most economists, who fret less about short-term fluctuations and market psychology. They argue that last year's sharp rise in interest rates will restrain the economy in 1995. Economic stimulus from the more recent decline in long-term rates probably, in their view, won't kick in until early next year--perfect timing to revive a flagging economy and send it on its way.

Most individual investors, of course, really shouldn't worry about short-term wiggles but should instead focus on the long term. And some strong arguments support the notion that long rates will continue to trend downward. Fidelity's Haber, though not a fan of U.S. bonds right now, believes long-term yields could eventually fall to the 4% to 5% range sometime this decade. If the federal deficit is reduced to, say, $100 billion--not an impossibility, given all the tough talk in Washington--Haber says long rates should revert to their historical spread of three percentage points above inflation, which he projects at 2.5% or so, for a bond yield of 5.5% on average. Throw in a mild recession and the yield dips below 5% at some point. The real payoff for the bond market and for the economy as a whole could come from what some economists view as a sea change in U.S. productivity, flowing in turn from the three-year-old boom in capital spending. A fundamental and permanent productivity pickup would cap unit labor-cost increases, hence inflation, hence interest rates. Gary Shoesmith, a professor of economics at the Wake Forest University business school, thinks long rates will slide as much as two percentage points in the next few years because of higher productivity combined with a slow-growing economy. Richard Hokenson, chief economist at the investment firm Donaldson Lufkin & Jenrette, expects productivity growth to climb to 1.75% a year on average this decade, up substantially from 1% in the previous two decades. By the end of the 1990s, he sees long-term interest rates heading toward 4%.

Even at 4%, long-term interest rates may never make it on the evening news, but investors and business executives across the country will be cheering, regardless.