Interest rate futures markets are increasingly baking in higher rates. A guru pointed out on Tuesday that Eurodollar contracts four years out have 3M Libor back around 4.75%. Then we have our classic 2/10yr yield curve at unprecedented record highs, today around 275, with the 10 yr adding 11 basis points since this morning’s jobless claims. As Bernanke said in his Testimony before the House Budget Committee yesterday, the rise in yields partly reflects deficit concerns, i.e. inflation, as well as signs that the pace of economic contraction may be slowing. There are also less obvious reasons, as in China dumping the dollar as its main reserve and treasury selling to hedge mortgage buying as the housing market show signs of bottoming. Is the rapid rise in yields premature or is it a hint that we are in for a ride?

The argument for rate action being premature is the point that foreign selling of longer dated maturity treasuries and mortgage-related selling are temporary phenomena and the market will digest these and stabilize. This may be, but just as some wanted to dismiss the inversion of our yield curve 2 years or so ago as “different this time” and not a signal of recession, I think it would be just as unreasonable to dismiss the steepening.

The other side of the coin has inflation being the cause of the recent spike in yields. There is the question if officials have gone too far to curb threats to financial instability. We heard the Kansas City Fed President Hoenig say the rapid rise in yields signals early market concern over inflation and the Fed must be alert to the market’s message. Although I lean more to this side, I don’t feel the need to adopt an extreme view. The expectation that the Fed will someday have to release all these treasuries on the balance sheet into the market may fuel the yield rise in part but it’s a little ignorant of anyone to think that this could happen in one fell swoop. Just as the buying is a measure of quantitative easing to help drive down mortgage and traditional lending rates it can be used as fire for quantitative hiking.

As Bernanke put it yesterday, “even after recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further.” That’s not to say that Bernanke himself is not worried about imminent inflation but does address the uncertainty with which policy will be applied going forward to maintain fiscal stability.

On a shorter-term note, we have May jobs data tomorrow. The majority seems to see it falling around -500K, but more significantly, the unemployment rate around 9.2%. If this is the case, it will be an employment scenario not seen since 1983. Bernanke warned in yesterday’s testimony that we can expect to see higher unemployment in the coming months. If these number s are better than expected, expect those in the camp that believe our steepening yield curve to be a sign of certain economic recovery to be saying “I told you so.” If not, use it as a chance to get in on the flight.