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Ten-Year Treasury Rates

On November 3, 2010, the Federal Reserve Board of Governors announced a second round of quantitative easing. Voicing concern over high unemployment, modest income growth, lower housing wealth, and tight credit, the Federal Open Market Committee (FOMC) stated that it intended to purchase $600 billion of longer-term Treasury securities through the second half of 2011, at rate of $75 billion per month. By purchasing longer-term securities, the Federal Reserve hopes to promote a stronger rate of economic recovery by reducing longer-term interest rates. The FOMC reaffirmed its commitment to longer-term Treasury purchases in its December 14 FOMC statement, citing that the recovery has been insufficient in bringing down unemployment.

Since the November 3 meeting, interest rates on 10-year Treasury bonds have increased. Between the November 3 and December 14 FOMC statements, rates on 10-year Treasuries have increased 90 basis points, from 2.57 percent to 3.47 percent. The rate on 10-year Treasuries is at its highest level since May 2010.

United States Treasury Rates

The increase in 10-year Treasury rates can be partly explained by examining changes in investors’ expectations about short-term interest rates. Thirty-day federal funds futures represent an excellent measure of the market’s perception of what short-term rates will be in the future. Since the November 3 FOMC statement, the October 2012 fed funds futures have increased 61 basis points from, 0.48 percent to 1.09 percent. The increase suggests that the market expects average short-term rates to increase, consequently driving up rates on longer-term securities.

In addition to examining investors’ expectations for short-term interest rates, it is also important to examine the factors that influence the premium investors charge for holding securities with longer maturities (the “term premium”). One principal factor included in the term premium is investors’ expectations of future inflation. Currently, inflation remains subdued, with the latest numbers from the Bureau of Labor Statistics showing that the CPI is up only 1.1 percent over the past 12 months. Additionally, according to the Federal Reserve Bank of Cleveland’s recent estimates of inflation expectations, 10-year expected inflation is 1.64 percent, suggesting that the public expects inflation to remain under 2.0 percent for the next 10 years.

Ten-Year Expected Inflation and Real and Nominal Risk Premia

Two other potential sources of the increase in 10-year Treasury rates are an improved economic outlook and an increase in the number of Treasuries issued by the United States government. The economic outlook may be improving on account of the recent proposal of a bipartisan tax plan (H.R. 4853), which includes an extension of all income and investment tax rates for the next two years, an extension of unemployment insurance benefits, and a reduction in the employee payroll tax. The passage of H.R. 4853 coincides with upward economic forecast revisions from economists.

Gross Domestic Product Consensus Forecast

  November (2011) November (2012) December (2011) December (2012)
Average forecast 2.5 3.1 2.6 3.2
Median forecast 2.5 3.1 2.6 3.3

Note: Yield curve inversions are not necessarily continuous month-to-month periods.
Sources: Bureau of Economic Analysis; Federal Reserve Board; and authors’ calculations.

The Congressional Budget Office estimates that the passage of H.R. 4853 will add $857.8 billion to the federal deficit, with the bulk of the increase in the deficit coming in 2011, 2012, and 2013. Given the moderately improved forecasted economic conditions and the likelihood that the federal government will have to issue new debt to finance H.R. 4853, it is possible that the increase in the 10-year Treasury bond rate is measuring the market’s perception that the quantitative easing program will end in mid-2011 at the same time the federal government will be issuing new debt to finance the tax plan.

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