Here come higher interest rates

NEW YORK (Fortune) -- Investors are kicking themselves for failing to spot the twin bubbles in the stock and housing markets when the laws of economic gravity for both became spectacularly unhinged. Now, America should be on red alert for another bubble that's destined to pop -- outrageously overpriced government bonds, the flipside being outrageously low interest rates.

Indeed, the trend towards far higher rates is already beginning: Since March, the yield on the 10-year treasury has jumped from 2.5% to 3.8%, sending prices­ -- which move in the opposite direction -- ­­down a staggering 34%. "We're in the early innings of a very long bear market in treasuries," warns Michael Darda, chief economist at trading and research firm MKM Partners.

As the yields march upwards, mortgage rates will follow, and a major justification for the government's massive deficits, the cheap cost of borrowing, will disappear. Look for the burden of financing the fast-rising federal debt to grow far heavier than the government's bluebird projections.

Two fates await. Big rate increases are inevitable, but they could follow two extremely different paths. We'll call one the sobering-but-healthy solution, and the other the disaster scenario. The critical choice rests squarely with the Federal Reserve.

In the former scenario, the Fed would start raising rates within a few months to combat looming inflation. Disaster would strike if the Fed succumbs to political pressure and keeps rates artificially low, sending buyers of Treasurys into a panic over inflation, and raising Treasury yields into the near or full double-digits.

Allan Meltzer, the distinguished monetarist from Carnegie Mellon, fears that the disaster scenario is far more likely. "We'll see tremendous pressure not to raise rates from Congress, the administration, businesses and the unions because of high unemployment," he told Fortune. "As the economy picks up, the Fed will need to scale back on money-supply growth, and in a replay of the 1970s, they will not do it."

To understand why rates are certain to rise, it's crucial to analyze the two components of yield on Treasuries and where they're headed: The "real" interest rate, and the inflation premium. Both building blocks are far below their historic averages.

First, let's examine "real" rates. It's the nominal yield on, in this case, the ten-year Treasury after adjusting for inflation. Right now, the real rate is extremely low. With the 10-year yield at 3.8%, and "core" inflation (excluding volatile food and energy costs) running at around 2%, the real rate stands at around 1.8%. That's far below the long-term average, which Brian Wesbury, chief economist at asset manager First Trust Advisors, estimates at 3%.

Normally, the real rate reflects the safe return investors that investors seek after inflation, the "real" return that allows them to buy more goods and services with their investment income, after all price increases.

So why are real rates so low right now?

Real rates. One obvious reason is the flight to quality. The financial crisis sent investors fleeing stocks, and especially bonds, for the safety of Treasurys. That bid up Treasury prices, and by late last year, drove real rates to zero.

Real rates have risen gradually as investors have sought higher returns by embracing modest risk. But they remain extremely low by historical standards. What's keeping them there is the Fed's expansionary policies. The rapid increase in the money supply, funded by enormous purchases of Treasurys from banks, is holding down the short-term rates that the Fed directly controls.

Right now, the reason investors are demanding more attractive real rates is chiefly because the flight to quality is waning. The evidence is the big drop in spreads on corporate and junk bonds, a sure sign that Americans will accept modest risk once again if they're adequately paid for it.

The economy is also starting to recover. Real rates wax and wane according to demand for new capital: When the economy begins expanding, competition among rival corporate borrowers floods the market with bonds and drives up rates.

Now let's look to the future, and the shadow cast by giant deficits. The government borrowing required to finance those enormous deficits could push real rates well above the normal level of around 3%. In most expansions, deficits drop because tax receipts swell with the recovery. But now, America is entering uncharted territory. The deficits remain a structural problem, not a cyclical one that will disappear with the recovery. They will remain in the $1 trillion a year range, even after U.S. reaches full employment and strong growth, according to the CBO forecast.

So the government will be competing for America's scarce savings at precisely the time corporations will need that capital to buy workstations, to open stores, and to add employees. The demand for capital from two directions, practically a first in U.S. history, threatens to substantially boost real interest rates.

The second component of government bond rates is the expectation for inflation. As in the case of real rates, the inflation premium built into the ten-year Treasury is too low right now. It doesn't come close to reflecting the big price increases in store for the U.S.

What's the inflation premium today? A good measure is the difference between the rate on Treasury Inflation Protected bonds, or TIPs, and the yield on the 10 year treasury. The TIPs rate approximates the real interest rate, so the difference is the expected rise in prices.

Today, the difference is around 2%. And in fact, inflation is now running at around 2%, excluding food and energy. But the smart money thinks that inflation will be far higher than 2% over the next decade.

In the Fed's hands. That brings us back to the two scenarios, sobering-but-healthy versus disaster. It's the Fed's choice, and investors should watch the Fed's decision with care and trepidation. If the Fed chooses the right path, sobering-but-healthy, it will start raising short-term rates this year or in early 2010. That would send a strong signal that the Fed is serious about fighting inflation.

Yet even that strategy won't slay inflation: Darda predicts that prices will rise 3% to 5% even if the Fed proves righteous. But that's about the best result America can hope for. It might also dampen the need for far higher real rates by cooling the economy temporarily when the government is doing its heaviest borrowing. The result would be 10-year rates of around 6% to 8%. Those yields would pound the economy for a year or more, but they would also put inflationary fears to rest.

Now, let's look at the disaster scenario that so worries Meltzer and Wesbury. In that script, the Fed would hold short-term rates extremely low to keep the economy growing and prevent further increases in unemployment. The easy-money stance would leave investors terrified about inflation. A new explosion in credit would push up demand far faster than the economy could supply new goods and services, causing a rapid rise in prices.

Instead of raising taxes to lower the deficit, the Fed would monetize it by printing money to buy Treasurys. That would scare Chinese and other foreign investors we rely on to buy our bonds and finance our deficits. They might resort to panic selling. Now we're talking about rates that could reach the double digits.

Allan Meltzer, author of influential histories of the Fed, isn't giving specific numbers, but he will say, "We're facing a major inflation problem. Three to four percent inflation is not a bad thing, but the Fed won't be able to hold it there."

Meltzer abhors the kind of political pressures that left us with rampant inflation in the 1970s. But the great man sees them building again. This time, we have a chance to escape what's obviously, clearly and undeniably a bubble. And we're on the verge of returning to the time when bellbottoms and hyperinflation reigned. The former went out of fashion. We all know the pain it took to escape the latter.