Fed nominee Janet Yellen (Photo credit: Wikipedia)

Janet Yellen will be pushed to defend the Fed’s easy-money policies on Thursday when sheappears before the Senate Banking Committee for hearings on her nomination to succeed Benjamin Bernanke as chairman of the nation’s central bank.

The Fed has a dual mandate, of course: To stimulate full employment and keep inflation under control. Conservatives fear Yellen will abandon the inflation bit and focus only on employment, letting prices and interest rates riseand accelerating the transfer of wealth from savers to spenders.

If rates go up, in other words, it will only be if Yellen wants them to. And that will only happen if the economy is recovering so quickly that the Fed needs to intervene to cool down the credit markets.

A study of eight past episodes where long-term rates rose more than 150 basis points, or 1.5 percentage points, shows they nearly always come as the Fed uses its main tool of monetary policy, increasing the federal funds rate it charges banks. The fed funds rate, in turn, is closely linked to longer-term rates. In the four episodes since 1990, 10-year Treasuries never blew out to more than about 400 basis points above short-term rates, suggesting a limit to how steep the yield curve can get.

“We think that’s a natural cap,” said Greg McGreevey, chief executive of Invesco Fixed Income. The reason is basic arbitrage:  As the spread widens, banks and other investors begin to use short-term borrowed funds to buy longer-dated paper, driving up the price and down the yield.

“There’s a direct relationship between the federal funds rate and the 10-year; they can’t get completely disconnected,” McGreevey told me after the conference. “So if the Fed keeps rates near zero it would be impossible for (10-year rates) to get to 5-6%.”

Even when long-term rates rise, Invesco’s analysis shows the impact on investors is surprisingly limited: In the four episodes since 1990 there were  losses in the year after rates climb, followed by gains as market rates overshoot the Fed’s target and fall again. Investors in a broad mix of Treasuries lost between 2% and 4% in Year One after a rate increase, Invesco found, then earned between 2% and 4% in Year Two and as much as 6% in the third year.

Investment-grade bonds also rose over a longer period, showing positive returns in all four episodes in Years Two and Three and much higher returns as rates rose following the financial crisis. Courtesy of Forbes.