For the time being, I am comfortable with where the 10-year bond rate resides -- around 250 to 260 basis points.
The yield on the 10-year TIPS is around 50 basis points, which is lower than I believe that it should be, but I can live with this positive return for the time being.
As those who have read my posts before (see my most recent post on bonds), I am a firm believer that the yield on TIPS was in negative territory for such a long period of time because of the financial turmoil in Europe. The movements in the 10-year TIPS yield over the past two months or so has been a result of investors in European sovereign debt being willing to take on more and more risk and leave their "safe haven" investments in US Treasury securities and German bunds.
As funds moved back into the riskier European securities, the yield on the 10-year TIPS moved back into positive territory and seems to have found a near-term level of about 50 basis points. I believe that this level will be maintained for the near term. Unless Europe falls apart again, which it could, I think that a 35- to 50-basis point plateau will be maintained as a floor for this yield until further improvement takes place in world markets and more funds leave the Treasury market for higher yields, at which time the new floor rate for this TIPS interest rate will move into the 75- to 100-basis point range.
Then, if financial markets' expectations about longer-term inflation remain in the 2.00 percent range, then the 10-year Treasury note should trade to yield around 2.50 percent, right in the range it now resides.
This is why, in the absence of any other information, I believe that for the near term, the 10-year Treasury yield is about where it should be.
I do believe, however, that this rate is still abnormally low and that it is low because there still is a lot of international money residing in the markets for US Treasury securities. If economic growth in the United States begins to tick up, I think we will see the yield on the 10-year TIPS begin to rise with the next bump taking this yield up to somewhere around 100 basis points.
If inflationary expectations remain around 200 basis points, this means that the yield on the 10-year US Treasury note should be at least in the neighborhood of 3.00 percent.
I think that this movement could take place within the next six months. The only question I have here is whether or not that with this kind of move in the bond market, a move created by continued modest improvements in economic growth, that inflationary expectations might also rise slightly. If inflationary expectations were to increase during this time period, the nominal yield on the 10-year note would, of course, rise further above 3.00 percent.
Where should the yield on these securities be going? Under more normal circumstances with more normal rates of growth of the economy, I would expect that the yield on the 10-year TIPS should be in the 2.25- to 2.75-percent range. Taking the average here, let's say that the yield on the 10-year TIPS should be around 2.50 percent.
Then, with no increase in inflationary expectations, I believe that the yield on 10-year Treasury notes should be at least in the 4.50 percent range, a full 80 percent higher than what these notes are trading at currently.
And what about any Federal Reserve tapering of its security purchases?
I am still not convinced that the Federal Reserve can do a whole lot about longer-term interest rates over an extended period of time. The Fed can keep short-term interest rates low for a long period of time, especially in times like the present when there is very little loan demand in the banking system, but the Fed does not have a major impact over longer-term interest rates.
To me, long-term interest rates have been so low over the past four years because the economy has been in such bad shape and because of the financial disaster in Europe. In the United States, real economic growth has been pitiful, at best, and this has not put any pressure on long-term interest rates. Furthermore, all the money escaping Europe has found a "safe haven" in the United States and this has done more to keep long-term interest rates down than perhaps almost anyone can imagine.
It is my belief that economic research in the future will produce results that will astound us all about the influence these international moneyflows have had on long-term US interest rates. Who could have imagined that the interest rate on US TIPS would turn negative and remained negative for two years or so? There is no way, in my mind, that the Federal Reserve System could have achieved this result. This yield configuration had to have come about due to international flows of funds.
So, I believe that longer-term Treasury yields are on the way up. The yield on the 10-year US Treasury note will remain in the 2.50 range for a while, but, I feel that in about six months or so, that this yield will rise, even reaching 3.00 percent or more. But this rate is still substantially below the rate it should be trading at given the economic future I see.
This rise, however, will not be the consequence of Federal Reserve tapering, because I believe that the Federal Reserve will still be erring on the side of monetary ease in the foreseeable future. And with Janet Yellen as Federal Reserve Chairperson in replacement of Ben Bernanke, I see little difference in the future path of Federal Reserve monetary policy. In fact, at this stage, Yellen has given us no evidence that she will be anything other than a clone of Bernanke. Oh, my…
I don't believe that there will be any wild generation of a spike in interest rates because I believe that economic growth will continue to be tepid although modestly improving and that loan demand will not be so strong as to drive rates up from the borrower side. Furthermore, given this scenario, I don't see actual inflation picking up steam reaching for a boiling point. Thus, inflationary expectations should stay modest. Thus, I would argue at this point against a real, rapid run-up in interest rates.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.