Keeping an Eye on Interest Rates

I think that it’s generally worth keeping one eye on long-term interest rates for indications of market expectations and behaviors. And over the past couple of weeks, this indicator has shown some interesting movement: long-term rates have made a decisive, if not dramatic, move upward. The 10-year yield has gone from about 3.95% to about 4.20% since the beginning of the month.

What does this tell us? One possibility is that market participants have changed their assessment of future inflation probabilities. Another is that they have revised their opinions of future economic growth (which creates demand for borrowed funds) in the US. Yet another possible explanation is that there has been some slight change in the interest of investors around the world to lend money to US borrowers.

The following chart illustrates that a change in inflation expectations can be ruled out. I think that that leaves options #2 and #3 as the possible explanations for this recent rise in interest rates.

Note: Inflation expectations measured as the difference between the 10-year nominal yield and the 10-year TIPS yield.

Who knows if this rise in rates will persist; the bond market’s penchant for keeping long-term rates surprisingly low has continually surprised many economists over the past year or so. But it is something worth keeping one eye on.