Why are long-term interest rates declining?

Long-term interest rates that serve as the benchmark for fixed-rate mortgages are declining once again, with 10-year Treasury note yields falling through the 4-percent mark. Why is this happening with short-term interest rates rising so consistently and the Fed voicing concern about an overheated housing market? There are several reasons that long-term rates have fallen in the past two months, and some big names think they'll fall even more.

Inflation is a key factor in interest rates, both on the way up and on the way down. The eight increases in short-term interest rates over the past year have brewed confidence that the Fed's efforts are ensuring modest inflation for years to come. The irony is that rising short-term rates have actually contributed to the decline in long-term rates.

Long-term interest rates have also benefited from a steady diet of foreign money flowing into U.S. securities markets. The dollar has suddenly been looked upon more favorably among foreign investors, with the rejection of a European constitution fueling the latest dollar rally and pushing the greenback to an eight-month high against the euro. When dollars are purchased, much of that money is then invested in Treasury securities, which helps to depress yields further.

Another contributor is the prevailing pessimism about the direction of the economy, and not just the U.S. economy. Japan and Germany, the second and third largest economies in the world, both have lower bond yields than the United States and are seeing anemic economic expansion -- if any at all. The high quality of U.S. government bonds, along with yields that are higher than what is available in some other countries, makes Treasury yields appealing on the world stage.

One theory is that if China's economy slows significantly, this would dampen the demand for commodities, smothering the key element of inflation. Lower inflation is music to the ears of bond investors, and they command lower yields as a result.

Bond investors also have a renewed interest in the quality of bonds. Integral to this assessment are the ratings assigned to corporate bonds by agencies such as Moody's, Standard & Poors and Fitch. Recent rating downgrades of both General Motors and Ford sent many money managers scurrying into a safer investment haven, with Treasuries a recipient of some of that money.

Repositioning by traders who were caught flat-footed as bond yields declined has also had an effect. With traders stampeding into Treasuries to cover their losses, this accelerated the decline in yields, particularly as the 10-year Treasury note neared 4 percent.

The declining yields have come despite the Fed's efforts to talk up long-term interest rates, such as Alan Greenspan's remarks about the "conundrum" of low long-term rates in the face of repeated increases in short-term interest rates. Lately, the talk has taken on a more-ominous overtone for homeowners and home buyers, with the Fed sounding repeated alarms about the speculation in the housing market. Greenspan mentioned the "froth" of the housing market and the likelihood of local housing bubbles. On May 27, Fed Governor Roger Ferguson said, "However, in some markets the most prudent judgment is that the growth of house prices will slow from the rapid pace experienced most recently."

But some titans of the bond world think yields could go even lower.

Bill Gross, managing director of Pacific Investment Management Company and the manager of the world's largest bond fund, had forecast in his widely read Investment Outlook that a range of 3 percent to 4.5 percent on 10-year Treasury notes would be seen over much of the next three to five years.

Morgan Stanley's chief economist Stephen Roach wrote, "At some point over the next year, I wouldn't be shocked to see yields on 10-year governments test 3.5 percent."

Declining long-term interest rates are pushing fixed-mortgage rates lower. The average 30-year fixed-rate mortgage has declined by one-half of a percentage point since March 23, from 6.15 percent to 5.65 percent. In turn, the housing boom continues as strong as ever, underscored by low mortgage rates. Until those rates increase in any appreciable fashion, the Fed's concerns about low rates fueling local housing bubbles are falling on deaf ears.