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Low interest rates have shored up the financial system and created a hot housing market over the last two years. But the days of easy money may soon be over, as the

Federal Reserve

could be forced to quickly correct mistakes it has made in conducting the nation's monetary policy.

Bond market moves and economic statistics strongly suggest that the Federal Reserve will have to raise short-term interest rates far sooner than many investors and economists believe. A hike in short-term rates could cause a selloff in bonds and stocks and a drop in house prices, but failure to act quickly could create even steeper declines.

Fed Chairman Alan Greenspan and other high-ranking officials appear to have committed one of the biggest mistakes in central banking: They lulled the bond market into deeply trusting the central bank and then did many things that were bound to break that trust. The recent rout in the bond market, which has sent yields on the 10-year Treasury bond to 4.23% from 3.07%, is a stark indication of that broken trust.

To win back the respect of markets, the Fed will now have to revert to behaving like a central bank that cares about traditional concerns, such as price stability and the level of the dollar. If Greenspan is in touch with market concerns, expect an increase in the federal funds target rate, currently at a meager 1%, by the end of this year.

So Much Data

So much data indicate that the market believes the Fed is behind the curve. One sign is the difference between the yield on three-month Treasury bills and the yield on 10-year Treasury bonds. When that gap is big, the yield curve is said to be steep. As of Thursday, there was a 3.3-percentage-point difference between the yields on the two bonds, which is a historically wide gap. That spread has increased as longer-term bonds have sold off.

Cash in the Barrel
Yield curve spread widens*

*Difference between yields on three-month T-bill and 10-year T-bond.
Source: Detox

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The simplistic justification for a steep yield curve is that it shows the central bank is keen to see a recovery -- and that a recovery is about to occur. The steepness also excites investors in financial stocks, because banks and brokers can borrow in the short term and invest in longer-term instruments and net easy profits. Indeed, nearly all banks have done that over the last two years -- and the increased steepness of the last two months means even greater profits from this play. And those earnings will help mitigate the capital losses in banks' bond portfolios caused by the recent bond market slump.

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.

Endgame

So what happens next? "The endgame is already under way," says Jim Bianco, president of Bianco Research. Bianco says the Fed is no longer treading the middle ground that all good central banks must tread, which is to foster consistent growth while avoiding excessive looseness or tightness in monetary policy. He says the federal funds futures market is predicting that the Fed will hike rates in February or March next year.

Greenspan is now in a bind. He could win back the bond market by trying to convince that there is enough weakness in the economy to soak up monetary stimulus. But the bond market probably wouldn't believe him now. A whole host of economic statistics says an economic recovery is under way, including a much higher-than-expected GDP growth figure for the second quarter.

The only thing the bond market will now believe is a hike in rates. The longer the Fed waits, the bigger it will have to be.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to

peter.eavis@thestreet.com.