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A simplified but mostly-accurate view of the world of rates holds that the continuum from short-term to long-term rates is also a continuum from rates set by policy to rates set by the market. So the interest on a ten-year treasury tells you what the market thinks the long-term cost of money is, while the rates on t-bills tell you what the Fed thinks the immediate cost of money ought to be.

Meanwhile, those near-term rates' moves are telegraphed ahead of time; the Fed recognizes that it's changing both the price of money and expectations thereof, so it can sketch out a plot of expected future increases, and give investors some sense of the uncertainty around those expectations. But these expectations have feedback loops: there isn't any edge in betting that the Fed will do exactly what it says it will, unless no one thinks that's true. And sometimes the market disagrees with the Fed's assessment, which is most visible when surprise rate cuts lead to higher long-term rates (i.e. investors are worried that they'll stoke inflation) or the reverse (the market worries that the Fed is going to kill off economic growth by preemptively hiking rates). Meanwhile, the longer-term a bond is, the more its rates also embed compensation for duration risk: long-term bonds are more rates-sensitive, and investors demand compensation for volatility. Even more annoyingly, the amount of compensation they demand is a function of how volatile rates are expected to be. And even more annoying than that, treasury bonds also have natural convexity: their sensitivity to a change in rates goes up as the rates themselves go down (going from 5% to 4% yield means a 25% price increase; going from 2% to 1% yield means doubling) (Edit: this is true for a perpetuity, but less extreme for a bond that also has a payoff at maturity. This, too, is something traders vary over time in their willingness to pay for. All asset prices are a one-dimensional projection of a multi-dimensional process, so they're noisy, but long-term rates are especially so.

And that means that intermediate-term rates are uniquely informative about what the consensus view of the Fed's actual plan is. Looking at the last three decades of rates, the longest continuous cycle was a bit over two years, when rates were rising in the mid-2000s after being cut nearly to zero after the dot-com crash. So, realistically, two-year rates encode everything the market believes about how the Fed will address whatever the most pressing problem is.

This raises what should be an interesting question: why do central banks usually move so slowly? Cuts from mid-single digit rates to near-zero rates, or the opposite, typically happen 25 to 50 basis points at a time, and mostly during scheduled meetings. Why don't they ever say "We're done with inflation. We're going to raise rates two points and see if you all start behaving more sensibly." And in the other direction, why not continuously update rates in response to real-time indicators?

The incremental approach makes sense, because the Fed is not just blindly applying an existing model to the current macro data. It's really in the business of continuously updating its model of the economy—an economy whose mechanisms are also, in part, a response to Fed policies. Every cycle has a different mix of marginal borrowers, and a different mix of groups with positive or negative exposure to floating-rate debt. Right now, for example, households are more insulated than usual from changes in rates, because mortgages were largely taken out at much lower rates and are still generally far from being refinanced. Meanwhile, corporate borrowers are using plenty of floating-rate debt; even if a rate hike doesn't kill them, it constrains their growth. As PE firms have shifted from buying stable companies with massive leverage to buying gradual-growth businesses with lower amounts of leverage, they've made corporate growth spending more rates-constrained than it used to be. But the long-term effect of that is hard to model, too; if a PE firm has a portfolio company that has promising opportunities to invest for high returns, but is short on cash for the moment, they're happy to financially-engineer their way out of that problem. The pacing and process of transmitting changes in rates to changes in the economy is variable and uncertain.

So central bankers do the prudent thing: make gradual changes, talk about the direction they plan to go in the future, and pay close attention to the reaction this produces. The future path of that is uncertain; the economic problems of 2024 are definitely not those of 2022, and very different from the ones of 2020. But the interest rate on two-year treasury bonds provides as good a look as you're likely to get at what the smart money thinks is the even-money bet.

Read More in The Diff

We've covered topics adjacent to rates many times in The Diff, including:

• How private equity firms taking control of life insurers actually reduces an important systemic risk ($).

• The structure of the levered loan market has interesting echoes of the subprime mortgage fiasco, but it's qualitatively different.

• Interest rates have declined over extremely long periods, but that decline is partly because of the introduction of effectively risk-free investments.

• A paradox of currencies is that reserve currencies are Giffen Goods ($): when there's a global economic shock that reduces the amount of tax revenue the US government can collect, it tends to increase the value of the dollar.

The rate of return that companies demand for their investments has a cycle all its own ($).

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