Wanna know when short rates will go up? Watch job numbers and the 2 yr bond

A major topic of conversation in investment land is when the fed is going to start raising rates. Consensus is for them to start doing so in the latter part of the year. However, history shows that the fed doesn't raise rates until there's clear evidence of a recovery in the economy and by clear I mean solid and consistent job creation. Right now there's none of that going on which suggests the consensus will be wrong.

It took 9 solid months of job growth before the fed started hiking rates during the last cycle in 2004. It took them even longer to respond after the 1990 recession. Job growth was strong for pretty much 2 years before they started hiking in February 1994.

Given Bernanke's reputation as an inflationist similar to Greenspan if not more so and the lingering effects of the shell shock due to the crash, I believe the fed is going to act in a similar way this time as well. They will error on the side of being too slow to raise rates in a meaningful way. At best, they may hike to .5-1% to remove the emergency level of interest rates, but until jobs on are the solid path to recovery I doubt they will go higher.

There's another way to speculate as to when rates will rise aside from looking at history. Pay attention to the behavior of the 2 year bond. The 2 year bond yield is very sensitive to the expected fed funds rate in the near future. In 2004 the yield in the 2 yr rallied strongly for 3 months prior to the first rate hike correctly anticipating the first hike in July 2004 and the series of hikes that were to follow.




In 1994 however, bond investors were caught flat footed by the first rate hike which occured in Feburary. But the yield subsequently surged big time and relentlessly after the first hike.




Currently the 2 year bond is saying "no dice" regarding the prospect of any rate hike anytime soon.




Although improving, the job situation is still weak and given the lingering shell shock from the crash, I believe that there will be no rate hikes in 2010. I originally believed there would be a sooner than expected hike but now I'm thinking the opposite. I'll probably change my mind if the 2 year bond yield breaks out. If however, there is a hike to 0.5-1% this year to remove the emergency status without any solid job gains, I expect that rate to remain in place until we see at the very least 9 months of solid job gains.