Bond Rout Will Push Fed to Tighten

But the steepness could evaporate if the Fed is forced to move short-term rates up, wiping out a huge source of bank profits. The big gap between long-term rates and short ones is likely more an indication that the market expects the Fed to hike short rates. The long rates are leading the way.

One possible argument against that bearish notion is that the yield curve was just as steep in the early '90s, when the Fed was trying to support the banking system and spur economic growth. But that overlooks two important facts. First, the Fed was slow to act then. For example, in 1994, Greenspan had to quickly raise short-term rates, hammering the bond market. And current monetary conditions suggest that the Fed may have to backtrack even more quickly than then. In the early '90s, money supply growth was weak and falling. Now, money supply is growing -- at historically high rates.

Nor does the current low inflation mean the Fed will keep from jacking up short-term rates. Inflation is now only marginally higher than it was in 1994. The Fed hiked short-term rates viciously in 1994, even though inflation was below 3%.

Of course, the Fed can hold its short rates as low as it pleases -- but there is always a price. The Fed targets the federal funds rate, which is the cost of borrowing the funds that banks use to meet their regulatory reserve requirements. If the rate on these funds is low, the banks will want to borrow funds here to invest in higher-yielding assets. When the yield curve is as steep as it is now, demand for cheap funds will be high. But if demand for federal funds is high, the interest rate on them will move up. If the Fed wants rates to stay low, it therefore has to make sure there is a supply of those funds to meet that demand. That supply creates the juice in the banking system that helps pump up money supply. In other words, the only way the Fed can keep the fed funds rate low in high-demand conditions is to pump up money supply.

Thanks, Easy Al Money supply growing fast*

*Year-on-year growth in monthly M2. Source: Detox

Until all hell broke loose in the bond market a month ago, bond investors didn't seem too concerned about the Fed's looseness. The market seemed to be buying everything Greenspan and other officials were saying about deflation. It didn't even freak when Fed figures suggested a little inflation may be a good thing. This was incredible: Bloodthirsty bond vigilantes had become vegans. Greenspan had taken a deeply suspicious beast and made it as trusting as a lamb.

Cutting It Thin Spread between 10-year T-bond and inflation*, in points

*Year-on-year change in monthly consumer price index. Source: Detox

The clearest indication of that is the difference between the yield on the 10-year bond and the inflation rate. That spread is the premium bond investors get paid for the risk of an overshoot in inflation. There was a precipitous decline in this spread between June 2002, when it was 3.86 points, and March this year, when it was 0.78 points, a low since the '90s.

But the Fed then got greedy. Though the bond market had become more trusting than ever, Fed officials continued to talk about the need for more stimulus, even as signs of economic growth popped up. As recently as July 30, Dallas Federal Reserve President Bob McTeer said: "We've got the target fed funds rate down to 1% and we've got money supply growing fairly rapidly. We may be on hold, but we're on hold with the accelerator down to the floor." Words like can these send a bond market tumbling in minutes.