Bond yields in southern Europe were rising, and a pervasive sense of apprehension and fear cloaked governments in European capitals.

Investors subsequent efforts to price in the risk of a eurozone breakup not the volume of sovereign debt caused bond yields to spike.

Italy and Greece, in particular, face serious debt issues amid financial market concerns about the possibility of default or their leaving the euro zone.

A negative oil shock, together with rising government bond yields could clip the recovery s wings and lead to a significant further downturn in asset prices and in the real economy.

The bond channel doesn t work when bond yields are already low and the credit channel doesn t work when banks hoard liquidity and velocity collapses.

Eventually, large monetized fiscal deficits will lead to a fiscal train wreck and or a rise in inflation expectations that could sharply increase long term government bond yields and crowd out a tentative and so far fragile economic recovery.

At this point, inflationary expectations will increase, long term government bond yields will rise, and the recovery will be crowded out.

The yen s rising value raises the yield on Japanese bonds relative to the yield on bonds denominated in other currencies.

How much safer, however, depends upon the returns on the pool of bonds that compose the CDO.

An expectation that interest rates will be high sometime in the next decade should mean high interest rates on long term bonds today.

But will tax revenues rise fast enough to offset the escalating cost of servicing the government s mountain of debt?

If interest rates were lowered beyond a certain point, the dollar would come under renewed pressure and long term bonds would actually go up in yield.

First, high commodity prices yield windfall profits for the region s leading producers of raw materials.

Long term inflation indexed bond yields have fallen to around 1 a year, or less, in the United States, Canada, the United Kingdom, and the eurozone.

Ordinarily, a sharp rise in oil prices quickly translates into higher inflation expectations, followed by rising interest rates at all maturities.

There is no other way to keep bond yields under control and banks functioning, and there is no ironclad guarantee that the reform programs needed to do the job will be approved.

If foreign holders of dollar bonds become concerned that the unsustainability of America s situation will lead to higher interest rates and a weaker dollar, they will want to sell dollar bonds.

One form of that diversification is to buy foreign bonds and stocks, driving up the value of those currencies.

Given this, we should expect Greek debt yields to rise further, despite the current IMF program.

Euro accession and bull market convergence trades pushed bond yields in these countries toward the level of German bunds, with the ensuing credit boom supporting excessive consumption growth.

Real estate rental yields and stock market payouts are low, and real estate and stock prices may well fall as much as or more than bond prices if interest rates spike.

At some point, the yields on bonds and mortgages will be high enough that investors appetite for yield will balance their fear of exchange rate depreciation.

The dollar would plummet. There would be financial distress and a deep recession.

Most telling is that Britain, which retained control of its currency, enjoys the lowest yields in its history, while the risk premium on Spanish bonds is at a new high.

While that could be contractionary, the gain in fiscal policy credibility might prevent a damaging spike in long term government bond yields.

As a result, the Fed has bought a massive amount of bonds without causing the stock of money and thus the rate of inflation to rise.

Privatization advocates insist, however, that investments in stocks would yield sufficiently higher returns to provide individuals the same retirement income as before, with the surplus used to fill the gap.

In this case, the price of loanable funds is the real interest rate. An expectation that interest rates will be high sometime in the next decade should mean high interest rates on long term bonds today.

Indeed, the stock market is an important component of any modern economy. But we should not make plans that rely on high returns, as many (including some governments) appear to be doing.

The higher interest rates go, the better are investments in bonds, which compete with investments in other assets such as stocks or homes.

When that happens, inflationary expectations will mount, long term government bond yields will rise, mortgage rates and private market rates will increase, and one would end up with stagflation (inflation and recession).

The relatively low interest rates on both short term and long term bonds are now causing both individual investors and institutional fund managers to assume duration risk and credit quality risk in the hope of achieving higher returns.

If the dollar is likely to fall against the euro over the next several years, investments in euro denominated bonds issued by the German or French governments may provide higher safe returns.

Expensive government bonds will shift demand to mortgage or corporate bonds, pushing up their prices.

Large budget deficits have led to high inflation in countries that are forced to create money to finance those deficits because they cannot sell longer term government bonds.

The Battle of the Bonds

As long as this combination of factors lasts, the governments of Latin America can maintain fiscal discipline, despite higher spending, as rapid growth translates into greater revenues.

And the prospect of rising short term rates means that investors no longer need to hold long term bonds to achieve a higher return over the next several years.

Criminalization of the laundering of proceeds of crime

Control of the proceeds of crime

Proceeds from revenue producing activities

Likewise, an IMF program for Ireland which seems increasingly likely will not bring down domestic bond yields and reopen credit markets to any kind of Irish borrower.

Bond lending involves diversified groups of bond holders, including domestic residents, and can be issued under different jurisdictions.

Buying time for reform to work requires socialization of short term risk. There is no other way to keep bond yields under control and banks functioning, and there is no ironclad guarantee that the reform programs needed to do the job will be approved.

Bond offering