One of the explicit purposes of the Federal Reserve's latest quantitative easing effort ("QE2") is to keep interest rates low. By purchasing Treasuries, it creates greater demand for the securities, which reduces their yield and should help to keep down interest rates on other financial products as well. So why, a few weeks after QE2 was initiated, do rates appear to be climbing? It might have something to do with the big tax cut compromise announced this week.

Treasuries Yields Rising

On Tuesday, Treasury yields rose sharply, with 10-year and 30-year bond yields increasing by 21 basis points. Of course, it's longer-term securities that are specifically what the Fed program is geared towards.Yet, they're rising.

Today, a Treasury auction reinforced the trend. John McDermott of the Financial Times Alphaville reports:

An auction of $21bn worth of Treasuries at 3.34 per cent was the highest bid since May, and well past the 2.64 per cent yield at last month's auction.

What has changed in the past few days? Easy: the President announced a giant tax cuts package that will increase the deficit by hundreds of billions of dollars more than forecast. The compromise more than doubled the size of the Bush tax cut extension alone, putting its total cost in the ballpark of between $700 and $900 billion. It will increase the deficit by the same amount.

Mortgage Rates Rising

But we're not only seeing upward pressure on Treasury yields: mortgage rates are also increasing. Last week mortgage rates hit a high not seen since July. Nick Timiraos of the Wall Street Journal provides the numbers:

The 30-year fixed-rate mortgage averaged 4.66% last week, up from 4.56% two weeks ago. That's still below the year-to-date average of 4.74%, but it's up from a low of 4.21% in October.

Of course, as Treasury yields rise, you can expect mortgage rates to rise as well. They have been increasing over the past several weeks, which has been causing refinancing activity to decline.

This must be pretty discouraging for the Fed. It had anticipated that a conservatively structured asset purchase program would be enough to keep rates from beginning to climb. That might not be the case. While it's hard to know precisely why rates are rising, one likely explanation is the new tax cut compromise. Bond investors may be frowning as Washington's spending exceeds even cynical expectations.

Rising rates are also generally bad news for the U.S. economy. Its sickest sector, the housing market, has a much better shot at recovering sooner if interest rates stay low. Low rates make home buying more attractive. Higher interest rates also make commercial loans and corporate debt more expensive for businesses, which will reduce their borrowing and expansion plans.