How much are yields going to rise?

The chart above shows Treasury yield curves past, present, and future, as calculated by Bloomberg. The date I chose for the past (April 30, 2013) marked the modern-day, all-time low for the 10-yr Treasury yield (1.6%). At the time, the Fed was half-way through its Operation Twist—buying 10-yr Treasuries and selling short- and intermediate-term Treasuries in an attempt to flatten the yield curve. QE3 wouldn't start until four more months or so. Economic growth had slowed meaningfully in the first half of last year, registering only 1.3% in the first quarter and 1.6% in the second quarter of 2013. The Eurozone was in a recession, the ISM index was disappointing, and retail sales were weak; the market didn't hold out much hope for the U.S. economy and so yields collapsed.

In the past year, the economic outlook has brightened, and yields have risen across the board. The Eurozone has come out of its recession, the Fed is winding down (tapering) QE3, there is no sign of recession, GDP growth has picked up, and stocks are 15% higher. 10-yr Treasury yields are up about 100 bps, even though QE3 has been in place throughout. Looking ahead, the bond market currently is pricing in a further increase of 60 bps in 10-yr yields over the next two years. Short-term rates, currently near zero (0.05% for 3-mo T-bills) are expected to jump to 3.3% in five years, at which time the yield curve is expected to be quite flat. In short, the market is pricing in at least 300 bps of Fed tightening over the next five years, and as much as 100-125 bps of tightening within the next two years.

The point of looking at future expected interest rates, which can be derived mathematically from today's yield curve, is to appreciate how much of an increase in future interest rates the market has priced in today. If future rates end up being equal to what they are expected to be, then it is impossible to make money by being either short or long. You can win a bet on interest rates only if they are higher or lower than what they are expected to be. Similarly, if you want to hedge against a rise in rates, then your hedge will only pay off if rates are higher than they are currently expected to be; if they aren't, your hedge will cost you money.

This is all very relevant for leveraged players and for those who make a living off the slope of the yield curve. The active players know very well that interest rates are expected to rise, so their strategies must be calibrated accordingly. Will the Fed raise rates faster or slower than is already anticipated? That is the question they must answer.

It is reasonable to think that a slower than expected economy and/or a lower than expected inflation rate would result in the Fed moving slower to raise rates, while a faster economy and/or a higher than expected inflation rate would result in the Fed moving faster.

In judging the risk of these two alternative scenarios, I'm inclined to favor the latter. I don't think it's possible for short-term interest rates to be 0-2% for the next two years when a) alternative asset classes offer substantially higher yields, b) a recession seems very unlikely, c) the public's demand for safe, short-term assets appears to be waning, d) banks appear to be relaxing their lending standards and have an almost unlimited capacity to lend, and e) businesses appear to be more inclined to borrow. These represent the stirrings-to-life of an economy that has been dragged down by risk aversion and is beginning to seek out risk. If short-term rates don't rise and become more competitive with riskier alternatives, speculative pressures could build and/or inflation could begin to rise, as money formerly socked away in risk-free places attempts to chase higher prices.

I've been worried about this sort of thing for a long time, and I've been premature as it turns out. But that's not a reason to stop worrying now. I don't think this risk poses a threat to growth, however. It's mainly relevant to those who are exposed to higher-than-expected increases in short-term interest rates and haven't taken steps to hedge that risk. For the rest of us, there's nothing necessarily wrong with higher interest rates. Indeed, they're already baked in the cake.