What Is Likely To Dominate Portfolio Returns Over the Next 2 to 3 YearsAuthor: John MasonLast Updated: November 21, 2013 Janet Yellen, in her recent appearance before a Congressional committee interviewing her for the position of Chairperson of the Board of Governors of the Federal Reserve System, stated that the best circumstances for the Federal Reserve to return to a more normal monetary policy would be achieved if the economy returned to a more robust pace of economic growth.Other analysts have said that it is perhaps the only way monetary policy can be normalized without major financial market disruptions.My concern here is with the future of interest rates.Longer-term interest rates in the United States have remained low, in my mind, for three reasons. First, the economy has been very weak. Second, the Federal Reserve has pumped massive amounts of reserves into the financial system. Third, the United States has benefitted in the past two years or so from large inflows of money from Europe seeking a “safe haven” for investment.Over the past six months, money has moved back into Europe from the United States as the financial situation in the eurozone has stabilized. This has resulted in the yield on the 10-year US Treasury bond to rise from about 1.70 percent to 3.00 percent before dropping to about 2.70 percent where it now resides.The first two reasons are still alive…the economy remains weak and the Federal Reserve continues to pump massive amounts of reserves into the financial system every month.Ms. Yellen also assured the Congressional committee that she would continue to support this approach if she became the Chairperson and would tend to err on the size of monetary ease until the economy exhibited a more robust performance, especially when it came to labor unemployment.Thus, if the economic growth continues to remain tepid…around 2.0 percent…the Federal Reserve will continue to inject reserves into the banking system…and longer-term interest rates will continue to remain relatively low.Economists argue that the real rate of interest should be somewhere in the neighborhood of the expected real rate of growth of the economy. That is, if the expected real rate of growth of the economy is around 2.0 percent, the real rate of interest should be around 2.0 percent.The yield on the US Treasury Inflation-Adjusted Securities (TIPS) is often used as a proxy for the real rate of interest. Right now, the yield on the 10-year TIPS is around 0.5 percent…150 basis points below the “expected” real rate of interest.Some of this differential is still the result of European “safe haven” money residing in the US Treasury market. The rest of the differential can probably be attributed to all the funds that the Federal Reserve is supplying the banking system.The difference between the “real” interest rate and the “nominal” interest rate is generally attributed to inflationary expectations. Right now, inflationary expectations are around 2.2 percent. It should be noted that inflationary expectations have not changed for at least the last six months…they have been very stable.Adding inflationary expectations (2.2) onto the expected real rate of interest (0.5) we get the nominal rate of interest, which now stands at 2.7 percent.If financial conditions continue to improve in the eurozone, the yield on 10-year TIPS should rise.If the Federal Reserve begins to cut back on its monthly purchases of securities, the yield on 10-year TIPs should rise.If economic growth picks up, the yield on 10-year TIPS should rise.Thus, if these three events occur and with no increase in inflationary expectations, the expectation has to be for a rise in the yield on 10-year TIPS and, hence, accompanied by a rise in the yield on the 10-year Treasury bond.According to Ms. Yellen’s testimony the second two of these three events are an integral part of her picture of an economic recovery in the United States and how the Federal Reserve will act in such circumstances. Therefore, if things get better, longer-term interest rates will rise.But, this seems to assume that price inflation will remain under control. Right now, all measures of consumer price inflation are well under the 2.0 percent policy guidelines the Fed wants to maintain. So, in the current environment price inflation does not seem to be of great concern.Hence, it would seem to be the case that inflationary expectations will stay relatively stable.However, the Federal Reserve has already put a lot of money into the economy, money that is just running around the financial circuit right now and not getting into the real production of goods.As long as these funds stay within the financial circuit, consumer price inflation is expected to remain dormant.The problem for the future is, and always has been, the possibility of these funds moving into the consumer and business spending causing a real increase in price inflation. And, if price inflation takes off…then inflationary expectations will take off.Therefore, if inflationary expectations rise…longer-term interest rates will rise.If the argument given above holds, then the only way longer-term interest rates will stay where they are now or lower would be in the case where the economic growth remains weak and the Federal Reserve continues to pump money into the economy to try and further stimulate economic growth.One of the problems with this scenario is that there is a large body of economic research that argues that over the longer run, the Federal Reserve cannot impact either economic growth or unemployment. These latter two variables are determined, not by financial factors, but by the workings of the “real” economy.If this is true then the Fed will have little or no impact on future economic growth, but can have a great effect on actual inflation and, hence, on inflationary expectations. And, if inflationary expectations rise, this will result in a higher yield on the 10-year Treasury security.So, given almost all possible scenarios laid out by Ms. Yellen…except for the one including the collapse of the US economy and price deflation…the future seems to contain a rise in longer-term interest rates.It seems like we are spending a lot of time talking about the future of interest rates and very little time talking about the characteristics of bonds and reasons for investing in the various types of bonds. The reason for this is that the reality of interest rate risk is very great in the current environment and may tend to dominate portfolio returns over the next two or three years. Because of this it is very important for us to understand what forces are working on the financial markets and to understand how the decisions of our policymakers might impact future outcomes.About John MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.