07/27/2011 09:44 EDT | Updated 09/26/2011 05:12 EDT

Federal Reserve Board Can't Keep Long Bond Yields From Rising

Even though the world economy is drowning in government debt, borrowing rates remained chained to record low rate setting by the G7 central banks.

In the U.S., the Federal Reserve has effectively anchored its key setting federal funds rate around zero. The Bank of Canada, for all its warnings about consumer debt levels, has its rate pegged at a very borrowing-friendly one per cent. And even the always inflation vigilant European Central Bank has only recently raised its trend rate to no more than 1.5 per cent.

Yet with each passing week, there seems to be more news of distress in government debt markets as governments grapple with record deficits. No sooner is one fire put out such as last week's decision by the European Union to extend a crumbling Greek economy another $109 billion euro hand-out than another one pops up like the looming Aug. 2 deadline for Congress to raise the debt ceiling or provoke a potential U.S. default.

Not surprisingly, the bond market is getting nervous. There is already is a four-percentage point difference between the U.S. Treasury's cost of borrowing in the Federal Reserve board controlled money market and the long bond market.

While a 4.25 per cent yield on a 30-year Treasury bond may seem low by historical standards, it is actually pretty high when you consider that thanks to the Fed's printing presses, the U.S. Treasury's cost of borrowing short-term money in the bills market is less than 0.5 per cent.

Of course, it is the inflationary consequences of printing all that money, as well as those that flow from the size of the deficits that they finance, that compel long-term lenders to charge the US Treasury over four per cent.

Lenders will soon have reason to charge the U.S. Treasury even more. And it's not because of the histrionics in Washington currently being played around raising the debt ceiling these days. More troubling is the prospect there is little hope the Obama administration and Congress will make any progress on deficit reduction until after the next presidential election.

And with triple digit oil prices lassoing growth, the bond market can't expect the economy to be giving Washington a helping hand on the revenue front .

Faltering growth and a near double digit national jobless rate may keep the federal funds rate grounded for another year. And failure to come to grips with the deficit, and another energy-price driven point or so rise in an already 3%+ inflation rate will see U.S. long Treasury yields reach new heights this year.