Yields on U.S. Treasurys drive all interest rates everywhere, except in moments when the proud owners of $5 trillion worth of mortgages try to protect themselves by short-sale hedging in the smaller, $3.5-trillion Treasury market. The last two months have been one of those moments; 10-year T-notes reached 4.84 percent at mid-week, and haven't done better than 4.77 percent since. A full percent rise in 60 days

There wasn't anything in new economic data to cause more damage, but neither was there anything to deflect the Fed's march toward neutralwherever neutral might lie. An increase from today's 1 percent to 1.75 percent by the end of this year is now embedded in the yield curve, and guesses run anywhere from 2.5 percent to 3.5 percent by the end of 2005.

Rates are likely to pause here at least until the May job numbers are released on June 4, and maybe until the Fed's next meeting, June 29-30. The next rate lurch is more likely to be up than down, but an ancient trading wisdom is a good guide here: once a market destabilizes in a powerful, out-of-trend move, then volatilitytrue up-and-down volatilitywill remain in the market for a long time. Few charts of any market, even during a long-term increase or decline, move in straight lines for long.

There is only one economic event that would quickly take 10-year yields well above 5 percent, and mortgages to 7 percent: an increase in perceived inflation. If the Fed's reflation campaign appears to spin out of control, Buzz Lightyear will take over as chairman: "To neutral, and beyond!"

There are some forces that could intercept the inevitable climb to neutral. The first of these is the stock market, whose unseemly trading this week limited the damage to interest rates. A lot of people are confused about the relationship between the march to neutral Fed funds and damage to stocks.

The "only-a-correction" types are right that the Fed could nudge up a couple of percent without doing any particular harm to a strong economy, or to corporate earnings. Earnings growth will slow, of course, as nothing compounds at 20 percent per year forever, and tremendous profit margins will beget tremendous competition.

The hazard to stocks appears in the land of "discounted present value" tough and weird math, but the key to the kingdom of money. A too-low discount rate tends to produce market bubbles: at a zero discount, the present value of any stream of earnings is infinite it is the sum of future earnings. Using today's 1 percent cost of money as a discount rate, the $100 earned in a 10-year, $10/year stream is worth $95 today, only a 5 percent cumulative discount to present value.

However, suppose future earning prospects remain steady, but the Fed funds rate rises to 3 percent; then the present value of the same earnings falls to $86. That adjustment is overtaking stocks, and will continue. If the Fed has to tighten past neutral, say to 5 percent, the present value of our example would fall to $78. Ker-plunk.

A stock market crater aside, another limitation on the Fed's return to neutrality would be a hard landing in China, where credit creation and inflation are running out of control. China has in two years flipped from a huge trade surplus to deficit, its imports increasing 43 percent in one year, mostly from Asian trading partners, all of whose economies would slow with China's.

High energy prices have been an economic brake in the last several years, but can easily return to the inflation propellant that they were in the '70s and '80s. Iraq is a rolling disaster, but has no particular economic linkage to the domestic economy, except for raising the deficit, which, if anything, tends to push the economy faster.

On netthe Fed will proceed because it has to. 

Lou Barnes is a mortgage broker and nationally syndicated columnist based in Boulder, Colo. He can be reached at lbarnes@boulderwest.com.

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