As Interest Rates Rise Inflation To Follow
We're all being subjected to a lot of jawboning these days about the notion that interest rates are not supposed to be rising - but rising is what they're doing on both U.S. government debt and mortgages. Fortunately for investors, market forces are not subjugated to government spin and media groupthink.

That's why I was able to predict, and profit from, this nascent move up in rates, despite criticism from some who argued that the removal









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of government mortgage market support and higher interest rates had already been priced into the market.

It's not only removal of Federal Reserve purchases of mortgage-backed securities that are sending rates higher. I believe the move higher in mortgage rates presages a higher cost of money across the yield spectrum, due to rising concerns about inflation.

The Fed's program of buying $1.25 trillion in mortgage-backed securities caused rates to fall to 4.71% in December 2009. After the Fed departed from the market, however, 30-year fixed mortgage rates jumped to 5.21% as of last week. That's up from 5.08% the prior week and the highest level in nearly eight months.

Unfortunately, this is just the beginning of interest rate woes as we now see the warning signs of burgeoning inflation all around us. The Institute of Supply Management's prices paid index surged in March from 67 to 75. Oil prices are up 65% in the last 12 months, and gold has reached a four-month high as it creeps back toward its all-time high of just over $1,200 per ounce. Even the prices of base metals, such as copper and iron ore, have surged recently. (For insight into the effects of changing interest rates, see How Interest Rates Affect The Stock Market.)

The Fed seems to regard these warning signs as things to ignore. Instead of dealing with our inflation problem, central bank officials have focused on stubbornly high unemployment numbers and troubles in Greece. The fact that people are unproductively sitting home in the U.S. and Greece does not obviate the need for the Fed to eventually deal with its mandate of providing stable prices.

Unlike his Australian counterpart Glenn Stevens, who recently raised interest rates to 4.25%, Fed Chairman Benjamin Bernanke seems undaunted by the warning signs all around him. In a Dallas speech last week he said "The economy has stabilized and is growing again, although we can hardly be satisfied when one out of every 10 U.S. workers is unemployed and family finances remain under great stress."

If investors need further evidence of Bernanke's dovish mindset, consider his comment that "We have yet to see evidence of a sustained recovery in the housing market. Mortgage delinquencies … continue to rise as do foreclosures."

Bernanke is correct about the real estate market. Lender Processing Services data released earlier this week shows mortgage delinquencies have risen to 10.2% and foreclosure inventories to a record high 3.31%.

Unfortunately, what seems to trouble Bernanke is everything except inflation. Not to be out done, New York Fed President William Dudley said on April 7 that the Fed Funds rate "needs to be exceptionally low for an extended period to contribute to easier financial conditions to support economic activity."

These Phillips Curve thinkers believe that a weak economy and falling home prices equate to deflation. The truth is that those factors can lead to deflation but they are not deflation in of themselves. (What's the Phillips curve? Find out in Examining The Phillips Curve.)

It is clear that the Fed isn't moving anywhere on rates in the near term. However, market forces are taking rates up on the long end of the yield curve. Rates are being pushed higher by three forces: the superficial recovery in the economy, which itself has prompt investors to cease seeking shelter in bonds; a tsunami of bond issuances; and credible concerns about the threat of inflation.

I am concerned about a rising rate of inflation, but I do not believe inflation will become intractable in the short term. That's because rising rates will have a severe detrimental impact on our over-indebted economy. In other words, the rising cost of money will be offset by the renewed weakness in gross domestic product.

Inflation will only become a massive problem if and when the Fed enacts quantitative easing to keep government debt service manageable. The Fed will ultimately be forced to decide between two bad choices - inflate our debt away by debasing its value via inflation or allowing the economy to collapse. History has proved that it's likely to choose the former path toward monetization.

For those who'd like to get a jump on hedging against inflation, I recommend ProShares UltraShort Lehman 20 (NYSE:TBT), Provident Energy Trust (NYSE:PVX) and Ordinary and Hecla Mining (NYSE:HL).





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