Interest rates are confounding to predict. Of course, the Federal Reserve is a lead influence, which is why market participants spend so much time parsing its every word. That said, most of the Fed's influence is focused on the short-end of the yield curve. By way of extrapolation, market participants then estimate longer yields. For example, if the current one-year yield is 1% and the market believes the Fed will lift that yield to 2% next year, the 2-year yield today should be 1.5% (1% plus 2% divided by two).

If life were only so straightforward. It's not. Money supply, wealth position, and expected inflation also play important roles. If the money supply increases and wealth and inflation expectations remain the same, interest rates should fall. With everything else held constant, more money can be allocated to financial assets, thus raising their prices and lowering their yields. On the flip-side, if money supply decreases and wealth and inflation expectations remain the same, interest rates should rise. With everything else held constant, less money means less money flowing into capital markets. Financial asset prices fall and yields rise.

So where does this leave us? We think wealth will at least remain constant. Inflation will likely remain muted. As for the money supply, it will likely decrease beginning next year due to the Fed withdrawing from quantitative easing and raising short-term rates. Based on this outlook, interest rates should rise in 2015.

Admittedly, we've been down this road before. We thought this scenario would play out this year. It hasn't, but it has to one day.

Information provided by Jessica Regan.

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