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Three Anchors For 10 Year Rates

Everyone expects 10 year treasury rates to climb in 2014. Everyone expects the Fed to taper, leading to an inexorable rise in rates. I would like to suggest that 10 year rates may remain in their current range in 2014.

The Fed wants to taper and eventually stop quantitative easing altogether. The only debate is about the timing. Quantitative easing is the Feds' version of Afghanistan. It is a quagmire. They would like to leave. They will eventually declare victory and extricate themselves. Contrary to popular opinion, Fed tapering will not signal an appreciably better economy. They have chosen feeble metrics like the unemployment rate to guide their decision. Tapering will happen, but it doesn't signal any real victory.

Here are some anchors that may hold 10 year treasury rates in their current range.

1. FORWARD GUIDANCE. Short term rates are at the zero bound and the Fed will probably strengthen their forward rate guidance language. They may lower the unemployment rate threshold from 6.5%. They may add a minimum inflation metric. The will not review short term rate policy until unemployment is below 6.5% and the inflation rate is above 1.5%, as an example.

2. LOW GLOBAL RATES. The BOJ is conducting its' own version of QE. The ECB may have to embark on QE in 2014 unless the pace of economic growth in the EU accelerates and inflation approaches the ECB target. US treasury versus Euro Bund spreads are approaching record highs, making that trade out of Bunds and into Treasuries more appealing. A collapsing yen is forcing Japanese investors to increase their purchases of foreign bonds. including US treasuries.

3. DISINFLATION. The PCE deflator increased at a 1.1% YOY rate in October. This Fed would prefer their favorite inflation metric to increase at a 2%+ rate. While they expect the inflation rate to pick up in 2014 that remains a big if.

In addition to these three anchors, there are other forces which may provide headwinds to increasing rates. The Fed has discussed paying 0% interest on excess reserves. They currently pay 25 basis points on several trillion dollars in excess reserves that banks are keeping at the Fed. They have even discussed making this rate negative. Doing so, would force banks into deploying at least some of these reserves. Buying treasuries is the quickest thing they could and would do.

Also, never forget that on any given day, some world calamity could spark a massive flight to quality into treasuries. The converse is not true.

Disclosure: I am long CYS, ZFC, MITT, EARN, AI, ORC.