Now that the Federal Reserve has taken a more aggressive posture regarding the need to raise the Fed funds rate, investors are placing speculative bets on rising bond yields. FOMC raised the Fed funds rate by a quarter point yesterday, but switched from ‘data dependent’ back to seeking members’ expectations. The members expectations are revealed in the so called ‘dot plot’, where voting members put down their expectations for future Fed funds rates, growth and inflation. Bond and stock investors, by and large, have latched onto these higher FOMC forecasts and have placed their bets accordingly.

 These bets have hit certain segments of the bond market hard, sending  short term yields dramatically upwards—the 2 yr note hitting  the 1.25 per cent mark and the 5 yr note reaching a level of 2.07 per cent. Bond investors are anticipating a return to ‘ normal’ rates faster than any time since the financial crisis of 2008.

If inflation is the ‘bogey man ‘of the bond market, that man does not seem to scare long term investors, those who purchase 30 year Treasuries. One would expect that in an environment of rising inflation expectations that the spread between short and long dated bonds would widen. The steepening of the curve is the measure of how much investors anticipate an inflationary impact on their returns and the need  for higher rates to compensate for the risk of going out on the curve.

Although the 30 - year bond yield has moved up  considerably, post-election, the actual spreads between different segments of the yield  curve have narrowed with respect to the 30 –year bond. The accompanying chart examines the spreads between 30yr-5 yr and 30yr-10 yr bonds over the past 3 years.

Clearly, long term investors are not spooked by the prospects of higher inflation. Quite  the opposite, in fact. The long term investors do not feel any urgency to be compensated relatively more for holding long-dated bonds and are comfortable in adding to their position at current levels. These investors do not buy into the scenario that the Fed is painting with their forecasts. After all, the Fed has consistently over-estimated growth and inflation since 2008 at just about every meeting. Its track record leaves a lot to be desired.

 In any case, a Fed that hikes sooner and faster than the economy warrants will dampen growth and inflation and eventually drive long bond yields down more than short rates.(The Fed made a mistake in raising the rate in December, 2015, only to witness long rates falling to historic lows by mid-summer.) Moreover, despite the rather upbeat outlook expressed by Chairwoman Yellen, recent data regarding such important activities as industrial production, manufacturing and trade, all continue to point to an economy that is marginally expanding and is far from inducing an  acceleration in consumer prices.