Why Interest Rates Keep Rising, Despite QE2

Keeping interest rates low is a linchpin of the Federal Reserve's quantitative-easing policy (QE2), a $600 billion bond-buying program aimed at stimulating the economy. The basic idea is that low rates will encourage businesses to borrow and expand -- including hiring more employees -- and will boost housing sales by making mortgages cheaper for potential homebuyers.

Unfortunately for the Fed, bond yields and interest rates having been rising since it began buying Treasury bonds as part of QE2 in the fourth quarter of 2010. And they seem likely to continue rising despite the massive intervention by the Fed. Here are some of the broader factors that are working against the U.S. central bank:

1. The Fed's policies are perceived as inflationary: Charles Plosser, a member of the Fed's policymaking committee and the president of the Federal Reserve Bank of Philadelphia, has been a leading critic of the bond-buying program. Although it's intended to pump cash into the economy and keep interest rates low, Plosser argues that QE2 may backfire by stoking inflation.

Inflation has been so low recently that the Fed has been more concerned about deflation and has been trying to get at least some inflation back into the economy. But it's a question of balance and control because inflation acts as a "hidden tax" on the economy: Goods and services cost more, leaving households and businesses less money for consumption and investment.

And inflation isn't just bad for wage earners. It's also the mortal enemy of long-term bonds. As inflation rises, yields (and interest rates) must rise too, lest investors lose money in buying a bond. If a bond yields 3% (about what a 10-year Treasury bill pays now) and inflation is running at 6% a year, the bond holder will lose 3% of his capital every year.

Even worse, the market value of the bond would plummet. To understand this, imagine the bond yield and the bond's market value as two ends of a see-saw. If yields decline, existing bonds rise in value. If yields climb, the value of existing bonds falls.

For instance, if bond yields rise from 3% to 5% -- still a historically low rate -- that would mean that all existing bonds would be repriced so that they, too, yield 5%. A $100 bond that now pays 3% -- or $3 -- would be worth only $60 at 5%. That's a 40% cut for the bondholder -- a very painful loss of capital.

This type of loss in value already has been happening. Bond funds saw declines of 3% or more in December as yields rose. No wonder the bond market is skittish about potentially inflationary Fed policies.

2.Investors expect higher interest rates and yields: As Vishesh Kumar reported here earlier this month, big-name investors such as Warren Buffett are anticipating higher interest rates and yields.

Because of that expectation, savvy investors aren't waiting for inflation to kick in to demand higher returns on their capital: They're demanding higher yields now in order to compensate for future inflation. And as bond buyers demand higher yields, this investor anticipation of higher rates can actually drive those rates up.

3. Global competition will push rates higher: The Federal Reserve doesn't maintain exclusive control of bond yields. They're also set by the global market for bonds, which is constantly balancing the risks of inflation and default against the yields of government and private debt.

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According to a lengthy report from the International Monetary Fund, nations around the world will soon need to issue new bonds to finance monumental sums of capital. This includes new bonds sold to pay off maturing bonds, as well as new bonds to finance current deficits.

The IMF expects the U.S. will need to finance roughly $4 trillion through new bonds this year, which amounts to 27.2% of the country's GDP, while Japan will need to raise some $2.5 trillion, or a staggering 59% of its GDP.

Add in heavy borrowing needs by other large economies, such as Italy, and the total demand for new bond-based governmental funding exceeds a whopping $10 trillion, a sum that threatens to exceed the supply of cash available to buy these bonds.

And that's just for 2011. With some governments, such as the U.S., running gigantic deficits every year, the need for trillions more in new financing will likely continue into 2012 and beyond.

The IMF warned that all the refinancing -- and the higher risk of default -- could erupt into a "full-blown sovereign debt crisis," which would surely drive rates higher for all borrowers, not just for at-risk borrowers like Greece and Ireland.

4. The U.S. is running unprecedented deficits: The U.S. is adding to the ballooning burden of global debt with record national deficits that have added a mind-boggling $5 trillion to the national debt since 2008. Why? The country's imbalance between tax revenues and spending is also unprecedented, with tax revenues of around $2.3 trillion and spending of about $3.8 trillion. It is borrowing $1.5 trillion -- roughly 40% of its expenditures every year -- to make up the gap.

Even if investors remain absolutely confident that the U.S. will never default on its rapidly rising debts, the supply of all the new bonds from other nations will likely exceed the overall demand for bonds. And that means interest rates will likely rise as governments and private bond issuers compete for investors' cash.