REVISITING THE INTEREST RATE DEBATE

Stocks surged forward at the open (Dow +430 pts; SPX +1%). Sectors up more than 1% in early trading include financials, materials, industrials and energy. The only sector not participating today is utilities. Commodities are also broadly higher. WTI crude oil is back up to $74.50/barrel; copper is up 1.9%; gold is up .4%. The bond market is decidedly mixed. As one would expect given the risk-on bent to equities and commodities, safe-haven Treasuries are selling off this morning. The iShares 20+ Year Treasury Bond ETF (TLT) is down 1.1% today (and -7% year-to-date). On the other hand, riskier corporate bonds are up modestly in early trading.

Today’s trade notwithstanding, the investing community is collectively scratching its head about the recent decline of interest rates. The 10-year Treasury Note yield has fallen to 1.35% from 1.74% at the end of March. The average 30-year fixed mortgage rate is back down to 3.05%. And coming at the time when prices for all kinds of goods and services are clearly rising, this phenomena is puzzling. Everyone is wondering why, as well as what it means for the future of this economic recovery. The following is a sampling of opinions:

Rates and inflation are typically correlated, but CNBC Contributor and money manager Josh Brown believes Treasury yields “are not to be used as a tool to predict inflation.” Historically, they haven’t been an effective predictor, and anyway, we’re talking about a very short period of time. He believes day-to-day movement in bond yields says more about supply and demand for bonds than anything else. For example, US Treasuries remain in high demand around the world because they are essentially risk-free and provide a positive yield. Recall that some other widely traded sovereigns (i.e. German, Swiss, Japanese) are trading at zero or even negative yields.

Long-time author of Grant’s Interest Rate Observer, Jim Grant, believes interest rates have been artificially repressed by Federal Reserve policy. The Fed is still buying $120 billion of Treasury and mortgage-backed bonds every month in order to keep interest rates low. He sees this stimulus as “unneeded” because the economy is recovering and inflation is a “clear and present risk.” In this scenario rates are too low, and thus he is unable to explain why they have fallen back recently.

Guggenheim’s Scott Minerd, on the other hand, says he predicted rates would fall back from March highs, and they could fall further. Rates, he argues, move with economic momentum and the very steep recovery trajectory we saw in the first quarter is beginning to moderate. Of course, it’s natural for economic growth to grow at its fastest pace during the very early stages of a new cycle, and then gradually moderate to more sustainable levels. In addition, he notes that the inexorable trend of rates over the last 40 years has been lower and he sees no reason why the long-term trend should change now. Finally, he notes strong foreign demand for US Treasury debt given the reasons listed above.