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Friday, the yield on the 10-year US Treasury inflation-adjusted bond (OTC:TIPS) closed above 50 basis points.

Exactly two weeks ago, the Federal Reserve's series on the 10-Year Treasury Inflation-Indexed Security, Constant Maturity shows the first positive yield on this issue since the fall 0f 2011. It shows a yield of a positive three basis points.

The yield had reached a low of a negative 90 basis points in December of 2012. For most of April 2013, the yield on TIPS was in the negative 70s.

I have recently discussed this movement into positive territory and argued that the initial cause of this move was that the money that had earlier left Europe seeking a "safe haven" in United States Treasury securities was now leaving these Treasury issues and was returning to Europe.

With the Bernanke press conference on Wednesday following the conclusion of the meeting of the Fed's Open Market Committee, the rise in this yield accelerated. The yield doubled on Wednesday after Mr. Bernanke announced the outcome of the meeting, and then almost doubled again on Thursday. The increase was not so great on Friday but the yield, nevertheless, rose further.

There was some concern at the Federal Reserve that the statements made at the press conference were misunderstood. An analogy was used to help explain how Federal Reserve officials interpreted the concept of a "tapering" of bond purchases. The analogy had to do with a speeding car. Federal Reserve officials interpreted the scenario they were drawing as one in which the driver of the car was just easing up on the gas pedal - nothing more. No big deal.

This, explanation, to me, just provides further evidence that Mr. Bernanke, and other members of the Fed leadership, don't really understand financial markets. (I believe that the evidence that they don't really understand how financial markets work goes back to when Bernanke was just a member of the Board of Governors from 2002 to 2005, as well as when he became Chairman. Further evidence of this lack of understanding was shown in his policy to combat the Great Recession by throwing all the "stuff" he could against the wall to see what might stick. This action may have prevented a deeper recession, but it was a desperation move to offset the Fed's errors on the other side that helped to create the recession.)

In this case, the speeding auto, to continue the analogy, created expectations in the financial markets that the excessive speed was going to be sustained for an almost unlimited amount of time. Thus, to participants in the financial markets slowing down the rate of speed…or even the idea that the car speed might diminish in the near future…broke down the expectations that the Federal Reserve had earlier created. That is, if monetary policy is not going to be as loose as it was, then, monetary policy is "tightening."

BB (Before Bernanke) the Federal Reserve, when it monitored money market pressures, was very cognizant about the expectations that existed in the money markets. "Breaking" expectations always caused significant "jumps" or "discontinuities" in the market, and so the Fed was very careful to move in ways that did not cause such a break.

Over the past several years, there have been very few "pressures" on the money markets. These money markets have been sufficiently "liquefied" so that concerns over market expectations have taken a back seat to just "buying bonds". The whole idea of "open market operations" seems to have been placed on a shelf because, under the existing realm of policy execution, that skill was unneeded. All the New York Fed's open-market desk had to do was buy, buy, buy.

Now, financial market expectations have been broken, the markets have reacted, and Federal Reserve officials seem surprised!

The thing is, I believe that the yields on TIPS are now getting back into the territory where they should be. In fact over the past three weeks or so, I have been writing that the yield on the 10-year TIPS should be rising toward 100 basis points, or 1.00 percent. This is still below where the TIPS yield has been historically. But, it is a good start. I just didn't expect that we would get into this range so quickly.

With the regular 10-year Treasury security yielding over 2.50 percent, the inflationary expectations built into Treasury yields seem to be holding. Right now, the inflationary expectations associated with the 10-year US Treasury security are around 2.10 percent to 2.20 percent. For most of 2012 into March of 2013, inflationary expectations appeared to be running in the 2.60 percent to 2.70 percent range. So as actual inflation has seemed to moderate over the past year, the expectations of inflation built into financial market yields has apparently declined.

Now, back to the future. As I have written recently, I still believe that the US economy will continue to grow but at the modest 2.0 percent to 2.5 percent rate that it has achieved over the past two years or so. This is due to the substantial restructuring that has to be completed before faster growth rates can be achieved.

If this growth is sustained, then I believe that the yield on TIPS will rise to 1.00 percent and slide on up to 1.5 percent. If inflationary expectations remain what they are during this rise, the 10-year yield on US Treasury securities should move into the 3.00 percent to 3.5 percent range.

A major concern, however, connected with rising long-term interest rates is the impact such an increase will have on commercial bank investment portfolios. Just last week, the Federal Reserve released information about the condition of these investment portfolios. As of June 5, the Federal Reserve noted, the net unrealized gains on commercial bank investment portfolios declined dramatically. And, as we have noted, interest rates have risen further since then. Whereas, over time, higher interest rates should help the net interest margins the banks earn on loans, in the shorter term, these rising rates will eat away any capital gains the banks might have in their investment portfolios and will exacerbate any capital losses.

As I have written for the past three years or so, at least part of the effort of the Federal Reserve to create financial market liquidity has been to keep commercial banks sufficiently solvent so that the FDIC can either close banks without disrupting financial markets or can oversee bank acquisitions that will reduce the number of problem banks in the banking system as smoothly as possible. This seems to have been working.

However, commercial banks have lengthened the maturity of their bond investments over the past three years in order to get higher yields on their portfolios. Any rise in longer-term interest rates will, therefore, be harmful. Furthermore, with the rise in rates coming as such a surprise, the banks will be less able to sell these securities to reap any gains that they might have. This could make the job of bank consolidation just that much harder for the regulators.

Of course, there still are several other possible scenarios that could interfere with this picture of rising US interest rates. The biggest concern is with the European situation. I recently wrote about this "unknown" as well as the "timing" of another European crisis. It just seems as if the Europeans cannot reach any kind of resolution for any of the major problems in must deal with. Then there is the concern over a possible economic slowdown in China.

Source: TIPS Move Solidly Into Positive Territory