Fed Policy and Stimulus Clash - 10 Year Treasuries Above 4%

The low rate policy of the Fed and the freewheeling spending of the Federal Government are on a collision course. Interest rates cannot stay low if the government is pumping money into the economy.

Chairmen Bernanke has tried to ameliorate the housing and banking crisis by driving long-term rates, those that are used to set mortgage prices down. To do that, he has directed the Fed to purchase Treasuries as well as mortgage backed securities. For a time it worked, and mortgage rates hit near record lows, prompting a flood of refinancing.

In many ways, this is the key to the economic recovery. Consumers are in trouble because they have too much debt, much of it housing related. Banks are in trouble because of the defaults on mortgage related lending. By lowering rates, Bernanke hoped to reduce both problems.

But the Obama administrations massive stimulus program threatens to undermine Bernanke's plan by driving up rates on longer-term Treasuries, which in turn lead to higher mortgage rates. Rates on Treasury bonds and notes have been increasing over the past couple of weeks and today, the rate on a 10 year Treasury went to 4% for the first time since last October.

Mortgage rates have responded in-kind. Fixed U.S. mortgage rates rose to the highest since November. The average 30-year rate jumped to 5.59 percent from 5.29 percent a week earlier, Freddie Mac, the McLean, Virginia-based mortgage buyer, said today in a statement. The 15-year rate averaged 5.06 percent.

There are two potential scenarios that I could see emerging:

1. The stimulus and the growing budget deficit revives the economy but at the price of rising inflation. The Fed will have lost any control it might have had over long-term rates and will be forced to quickly raise the Fed Fund rate.

2. Rising rates will meet the stimulus dollars and cancel each other out - resulting in an anemic recovery, if one at all.

I think option 2 is the most probable. One has to wonder if the economy might not be better off if the government cut back its spending plan and allowed the Fed to keep rates low.