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

Gold Is The Best Hedge Against Looming Inflation

Obama's Fed Pick Yellen Would Help Bankers, Hurt Families

Commodities A Better Store Of Wealth Than Dollar Or Euro

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).

Related Articles
  1. Investing

    What a Fed Delay Means for the ECB & BoJ

    The Fed’s continued delay has repercussions for more than just the U.S. economy and markets. The ECB and the BoJ may support the case for stocks in Europe.
  2. Economics

    Understanding Income Inequality

    Income inequality refers to the uneven distribution of income across a single economy.
  3. Economics

    Who is a Hawk?

    In the economic sense of the word, a hawk is someone who believes high interest rates should be maintained to keep inflation low.
  4. Investing Basics

    Explaining Fixed Exchange Rates

    A government using a fixed exchange rate has linked the value of its currency to the value of another country’s currency, or the price of gold.
  5. Investing Basics

    Learn How To Trade Gold In 4 Steps

    Trading spot gold or gold futures, equities and options isn’t hard to learn, but the activity requires skill sets unique to these markets.
  6. Economics

    The Effect of Fed Fund Rate Hikes on Gold

    Explore the historical relationship between interest rate increases and the price of gold, and consider what effect a fed funds rate hike might have on gold.
  7. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  8. Investing

    Latin America’s Economic Forecast

    After a ten-year run, the economies of Latin America are in a decline. For sustainable, long-term growth, the region needs structural reforms.
  9. Economics

    Why the Euro Failed to Become the World's Reserve Currency

    Examine the current state of the U.S. dollar as the world's reserve currency; learn the major reasons why the euro has failed to replace it in that capacity.
  10. Investing Basics

    How to Use Boring CDs to Diversify

    Markets are volatile and are in for more punishment. CDs can help investors earn some interest while they're waiting out the storm.
  1. Who decides to print money in Russia?

    The Central Bank of the Russian Federation (CBRF), like its peers in most countries, is the governmental entity responsible ... Read Full Answer >>
  2. Who decides to print money in Canada?

    In Canada, new money comes from two places: the Bank of Canada (BOC) and chartered banks such as the Toronto Dominion Bank ... Read Full Answer >>
  3. Who decides when to print money in India?

    The Reserve Bank of India, or RBI, manages currency in India. The bank's additional responsibilities include regulating the ... Read Full Answer >>
  4. Is Japan an emerging market economy?

    Japan is not an emerging market economy. Emerging market economies are characterized by low per capita incomes, poor infrastructure ... Read Full Answer >>
  5. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  6. Is Argentina a developed country?

    Argentina is not a developed country. It has one of the strongest economies in South America or Central America and ranks ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  2. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  3. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  4. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  5. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  6. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!