Where the signs are pointing to higher interest rates

If you've been on the fence about buying a new house or a new car, now's the time to act.

That's the message coming from the bond market, where turbulence has pushed down prices and pushed up yields. Last week, the 10-year Treasury yield climbed to a high around 2.35 percent -- testing a level not seen since December. Compare this to the low of 1.68 percent hit in early February. On a weekly basis, the 10-year yield hasn't initiated an aggressive uptrend of this type since early 2013.

This move comes despite growing expectation that the Federal Reserve will be forced to delay any short-term interest rate hike until September or possibly into early 2016. The U.S. economy badly stalled in the first quarter (Wall Street estimates for revised first-quarter growth are dropping below -1 percent), and recent data on the second quarter isn't looking much better. The Atlanta Fed's GDPNow estimate currently stands at 0.7 percent.

The futures market is focusing on September as the most likely date for a rate liftoff, but the odds of a delay into early 2016 are growing.

The long-term bond market is singing a different tune. Less affected by monetary policy, and more influenced by market-based factors, yields here have been drifting higher in indifference to the lack of action by Fed officials. And that's set to continue.

Two things are driving this rise.

The first is that inflation expectations are increasing, thanks largely to the recovery in energy prices from lows set earlier this year. Wholesale gasoline futures are up 67 percent from their January low. Crude oil is up 41 percent from its March low. The unemployment rate has dropped to just 5.4 percent -- nearing estimates of full employment and increasing the chance of a surge of wage inflation later this year.

The second is that "real," or inflation-adjusted, yields are rising as bond traders prepare for a rebound in economic growth in the second half of the year, according to Capital Economics. While U.S. consumers have been uncharacteristically miserly so far this year, we should see spending reaccelerate, assuming energy prices stabilize, job gains continue (as suggested by the ongoing decline in weekly jobless claims) and take-home pay starts rising as expected.


Bond yields have placed a big bet on this happening, as shown in the chart above comparing the 10-year yield to the Citigroup Economic Surprise Index, which rises and falls based on where the economic data is coming in vs. expectations. The data is currently underperforming on a scale not seen since 2012. The rise in long-term interest rates suggests we're on the cusp of a turnaround.

Credit Suisse analyst Andrew Garthwaite expects the 10-year yield to rise to 2.8 percent by the end of 2016 as the 32-year U.S. bull market in bonds comes to an end. That would push up borrowing costs to levels not seen since late 2013. If the Fed falls behind the curve on inflation, if the economy revs up more than anticipated or should crude oil zoom higher, yields could easily break above 3 percent and beyond.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.