By: Larry MacDonald

Could it be the early glimmerings of a policy bind? It seems the more the stock market rallies and the economy quickens, the more yields on government bonds climb. Of note, the 30-year U.S. government bond jumped to 4.3% last week. And despite the Federal Reserve allocating $300 billion to buy up the 10-Year Treasury note and hold its yield down, it rose to 3.3% last week (up from 2.2% in November).

That’s not especially good news. Yields on long-term Treasuries affect a wide range of interest rates in the economy, from mortgages to auto loans. When they go up, so does the cost of buying a house or car – not exactly the right medicine for getting out of recession.

But the more the economy picks up, the more the flight to safety unwinds and inflation fears revive. Let’s hope that the economic turnaround doesn’t ramp up too quickly and intensify selling of government bonds on these two fronts.

For the rise could potentially get out of hand considering other upward pressures on yields. One is the tsunami of new government bonds being issued as a result of the U.S. government’s massive spending plans on guns, butter, bailouts, and gargantuan stimulus packages. These plans are epic: they are projected to raise the 2009 fiscal deficit to a 60 year high of 12.5% of GDP.

Yet another source of upward pressure may be the huge domestic stimulus program in China. It’s even more massive the one in the U.S. and seems likely to lessen the importance of exporting to the U.S. as a means of promoting industrialization in China. That could lower China’s need to hold its exchange rate down against the U.S. dollar, and, in turn, it’s buying of U.S. dollars and parking them in U.S. government bonds.

If U.S. government bond yields do get too far out in front, they risk choking off the recovery. If this eventuality becomes apparent while the economy is still trying to find its feet, the Fed would likely print even more money and buy up Treasuries in greater quantities to keep yields low. So there could still be an upswing in the economy but it probably will be more violent and short-lived since inflation is likely to begin galloping sooner and compel the Fed to take liquidity out of the system.

So the aftershocks of the financial earthquake of 2008 may be felt for years to come in the form of more extreme fluctuations in economic activity. Maybe it’s back to the 1970s?

Conducting monetary policy will certainly be a challenge to say the least. It would appear we are threading the needle on this one. As I said before, it reminds of a scene in the computer-animated movie, Polar Express, my 6-year-old used to watch. In it, a train full of children runs off the tracks onto a frozen lake. With the ice breaking up behind it, the engineer guns the swerving locomotive toward the railway tracks on the other side and, just as the water is about to engulf the passenger cars, hits the rails square on and speeds to safety across the Arctic tundra.

Hopefully central bankers of the world will be able to pull off a similar feat. In any event, holding government bond yields down by printing money does not seem to be a sustainable policy.  As mentioned previously, it may be a good time to start, or add to, a short position on government bonds – especially if the Fed does step up its monetarizing of Treasuries and succeeds in pushing rates back down for a time.