Is the Fed playing “catch-up” with the bond market?

The federal funds rate is now expected to rise to less than 3% in a decade’s time, judging by the risk-neutral US Treasury yield curve. This rate remains well below the average projection of FOMC participants of the “longer run” level of the federal funds rate, even though the latter has been revised down substantially in recent years. Admittedly, the risk-neutral 10-year Treasury yield reflects expectations for the federal funds rate over an entire decade. But there would seem to be little scope for the yield to fall unless the long-run level of the federal funds rate is well below 3%. And even if the long-run level is that low now, the risk-neutral yield could rise if – as they have done in the past – investors revise up their near-term expectations for the federal rate in response to the onset of tighter policy. Since the term premium is also still very small by the standards of the past, we continue to forecast that the 10-year Treasury (par) yield will climb – our end-2016 forecast is 3%, compared to a current level of around 2%.