It’s Inevitable That Interest Rates Will Keep Rising — Here’s the Proof

They say a picture is worth a thousand words, and this week, you’re going to get 2,000 words that practically prove interest rates will rise.

Below are two charts that tie together everything I’ve been saying about Federal Reserve policy, historical interest-rate patterns, fundamental truths about the interest-rate markets and more.

First up is a weekly chart of two-year Treasury yields — one that goes back to the start of the century. Those yields are among the most sensitive to changes in Fed monetary policy. That’s because the underlying securities’ maturity is closer to the Fed’s overnight rate than, say, 30-year bonds.

Click for larger version

A couple of things jump off the page right from the start. The first is that two-year yields have breached the 100-week moving average to the upside. Second, the moving average has turned up for the first time since 2004 in the past couple of months.

But this is not a short-term trading signal, the kind that sets off triggers all the time and ultimately proves meaningless in the grand scheme of things. Instead, it’s the kind of longer-term technical signal that points to higher short-term yields. And not just for a brief period of time, but for a period of years.

Take the last signal in 2004. Two-year note yields surged from around 1.75 percent to more than 5 percent, an increase of 325 basis points. What’s more, the advance lasted a full three years.

Second, below is a chart of five-year Treasury yields that represents the “belly” of the yield curve. It dates to 2001.

Click for larger version

You can see the post-tech bust, post-9/11 collapse in yields. You can also see that the first leg down ran out of gas around September 2002.

Then it got a secondary push lower in mid-2003 when former Fed Chairman Alan Greenspan and his cohorts freaked out about potential deflation and an economic collapse. They pushed down short-term rates to a then-record 1 percent. Stories at the time suggested the Fed would keep interest rates low for a long time, and the central bank itself talked up the benefits of easy money in its press release. (You can read it online here.)

In 2003, Alan Greenspan drove down short-term interest rates to a then-record 1 percent.

But you know what happened shortly afterward? Investors started to sniff out a change in trend, and they began to sell their Treasury notes. That drove interest rates higher.

The final straw came in March 2004, when yields made a higher high (or right “shoulder” in an inverse head-and-shoulders pattern, if you prefer to look at it that way). That ended a period of about 18 months of rate-suppression purgatory.

What happened next? Rates took off like a Polaris missile. Five-year yields ultimately didn’t stop until they had surged all the way from 2 percent to 5.25 percent — again, a full 325 basis points.

Now take a look at the right-hand side of the chart. You can see the initial collapse in yields that accompanied the credit crisis, followed by the secondary declines on QE1 and the debt ceiling collapse. The move lost momentum around September 2011, and ultimately bottomed out in mid-2012.

You can then see how yields failed to make a lower low in late 2012, despite the launch of QE3. Following that, rates notched a significant higher high this spring, and ultimately shot higher. They surged from just 0.65 percent or so to a recent peak of 1.85 percent (before taking their recent “breather”).

Three things should jump off the page at you here:

One, the 19-month interest-rate bottom this time around was incredibly similar to the 18-month bottom from 2002-2004.

Two, both bottoming periods were accompanied by deflation fears, significant worries about the economy, Fed pledges to keep policy accommodative, and similar news stories saying rates will stay extremely low for a long time.

Three, the move of around 120 basis points from the recent trough to recent peak is just a small fraction of what we saw last time — more than 200 basis points less.

Or in plain English, when I look at the interest-rate markets, I see a world of opportunity now that Fed-related “noise” has filtered through the markets.

I believe we’ve made a significant long-term bottom in yields. I believe most of the conventional “wisdom” about interest rates and Fed policy is just plain wrong. And I believe we have much further to go in this rise, if history is a guide.

Until next time,

Mike