It’s better to stir up a question without deciding it, than to decide it without stirring it up.

~ Joseph Joubert

Update: This article was included in the Carnival of Financial Planning #150 posted at Military Finance. Thank you!

I’m going to try to raise some of the key issues that might affect interest rates over the second half of 2010 and beyond. Like most of the economic and market analysis we undertake here, these will just be the observations of an interested amateur. They are designed to be food for thought, and not definitive investing advice.

Interest Rate Drivers

On Monday we looked at inflation and deflation. Getting the call on that debate right will likely determine the relative success of any portfolio over the next decade or so. It will also have a profound effect on interest rates. But there are other factors that could affect different types of rates too.

In the end, bond traders and their views on the economy, inflation, monetary policy and fiscal policy are probably the main drivers of interest rates. Let’s look at how this happens and what might be on the minds of bond investors for the rest of this year:

1.  The Economy

Generally, robust economic conditions lead to higher stock prices and lower bond prices (higher interest rates). When the market rebound began in March of 2009, market participants began to anticipate positive economic effects from government stimulus. But if investors start to worry about the economic outlook as they have recently, they may reduce their equity positions and buy bonds instead, leading to lower stock prices, higher bond prices and lower bond yields (lower interest rates).

2.  Flation

Which type of flation we experience (and the timing of it) will affect the course of interest rates. Typically, deflation leads to lower rates, inflation and stagflation lead to higher rates, and hyperinflation leads to really high rates. Right now, most bond yields are falling, telling us that deflation is present – or at least that bond traders think it might be.

3.  Monetary Policy

Monetary policy usually refers to the ideas and actions of central banks, often led by the U.S. Federal Reserve. The Fed generally controls very short term interest rates. This is the rate they set every couple of months at those meetings you hear about on the business news.

Central banks have kept short term lending rates at record lows – near zero – since the onset of the credit crisis. Given the prevailing instability in global economies and credit markets, it doesn’t look like they are likely to raise rates any time soon. The only thing that could change that would be a dramatic improvement in economic conditions in the absence of government stimulus, or some persistent whiff of inflation. Right now, it seems like the Fed governors would like to see at least a bit of inflation to reassure themselves that we are not on the precipice of a deflationary spiral.

4.  Fiscal Policy

While folks can get into some pretty lively debates over monetary policy, fiscal policy is the one that seems to make most people really mad. Fiscal policy refers to the spending and financial laws enacted by the government. Most polls indicate quite a bit of disappointment with the way fiscal policy is being handled and that disappointment extends to the trading floors where bond prices are set.

If bond traders become truly disenchanted with the persistent deficits and burgeoning debt loads of governments worldwide, they will express that disappointment with their wallets. A loss of confidence in the ability of anyone, whether it’s a government or a corporation, to pay their debts leads the lenders (bond investors) to ask for higher risk premiums. This would mean a fall in the price of the offending government bonds and a coincident rise in interest rates. That has me wondering if markets would greet another stimulus package with the same enthusiasm as the last one. What do you think?

Bond yields in different countries don’t always move in unison. Recently, we’ve seen government bond yields for countries with debt problems surge, while rates in the rest of the world have plummeted as investors viewed those countries as safe havens. That seems logical until you consider that one of the places investors have sought shelter is in the U.S. treasury market. Yesterday, the 10-year U.S.treasury yield fell below 3% (a 14-month low) and the the 2-year yield hit an all time low, falling below .60%.

Yes, the U.S. represents a large, liquid, dynamic market and economy. It’s also one of the biggest debtor nations on the planet, so one has to wonder how safe it is to find respite in the nicest house in a really bad neighbourhood. (We discussed the prospect of bond market indigestion in our last interest rate commentary.) No one ever claimed markets had to make sense – unless you believe in Modern Portfolio Theory, I guess.

So Which Is It? Higher or Lower?

The answer to this question, like the inflation or deflation question, is likely “yes”. David Rosenberg has been bearish on equities and fairly bullish on bonds for a while now. I would highly recommend the article from Credit Writedowns that outlines his position. He believes that a double-dip recession is likely and that interest rates will go lower as the global economy weakens and deflation takes hold. We’ve seen that happening already. He thinks that supply and demand issues in the treasury markets are less influential and cites some historical precedents for that.

Larry MacDonald highlighted an interesting opposing view from Bud Conrad, who actually thinks that interest rates are a better bet than gold. Mr. Conrad thinks that interest rates are headed much higher – well into double-digits – as government borrowing needs increase and compete with corporate borrowing demand, “especially during the recovery phase of the economic cycle”. The latter statement is probably where Conrad’s case may prove to be incorrect, or at least premature. Those in Rosenberg’s camp would say that we are not in a recovery phase and that this is not a normal economic cycle because we’re in the process of a multi-year period of global deleveraging in the aftermath of the bursting of a massive credit bubble. (Whether ultra-low rates caused that bubble in the first place is a debate for another day.)

How Will Interest Rates Affect Your Investments?

In light of all of the confusing information above, investors could be forgiven for feeling a little dizzy, throwing up their hands and putting some money in a savings account. That’s one way to handle it, but if you want a few other ideas, a follow-up article from Larry MacDonald offers Mr. Conrad’s ideas on how to invest in rising rates. (Incidentally, Jon Chevreau mentioned a new Claymore ETF (CIB) that is bearish on the Canadian 10-year bond.) Bear in mind, though, that if Mr. Rosenberg is correct, these investments won’t work. In that case, you would be better off with some bonds and lots of cash.

I’m finding the cross-currents of the current market to be pretty confusing myself. New information can come along each and every day. Witness the market upheaval caused yesterday by a failed ECB (European Central Bank) sterilization auction and a lower leading economic indicator out of China. I think markets will continue to be buffeted by these kinds of events until the global deleveraging process is complete. That makes any investment riskier than normal.

I think interest rates will mostly remain low while deflationary forces are present. But I do see some potential for the scenario proposed by Mr. Conrad. One failed U.S. treasury auction is all it would take for bond yields to turn higher very quickly and perhaps by more than any of us think is possible at the moment. This is no time for ostrich investing. Stay alert, stay nimble, and protect your capital.

What are your views on interest rates half way through 2010?