Talk about a negative feedback loop: It looks like investors' expectations for an economic recovery could end up delaying that very scenario. Fear of inflation and concerns over the long-term impact of ballooning government debt have been driving up yields on 10-year U.S. Treasury notes, which reached 3.91% on June 8 before easing back to 3.84% the next day.

But hasn't the Federal Reserve been working overtime to keep rates down? The prime reason for the Fed's commitment to buying Treasury debt was to lower mortgage rates to revive the moribund housing market. That was starting to work, but economists are now warning that rising mortgage rates will stop any rebound in the housing market in its tracks and derail the broader economic recovery.

In its Weekly Credit Outlook published on June 8, Moody's (MCO) said that the Economic Cycle Research Institute's [ECRI] leading index of U.S. economic activity is now showing the recession nearing an end, with the possibility of higher mortgage yields the only remaining hindrance to a recovery.

The results of Freddie Mac's Primary Mortgage Market Survey, released on June 4, showed a jump in the 30-year fixed mortgage rate to an average of 5.29% for the week ending June 4, compared with an average rate of 4.91% the prior week. Last week's rate was the highest since the week ending Dec. 11, 2008. With Treasury yields even higher so far this week, the 30-year mortgage rate is being quoted as high as 5.50% on bank Web sites such as Citibank's (C).

A Diluted First-Time Buyer Tax Credit Mortgage rates should trade at a premium over 10-year Treasury notes to account for the greater risk. That premium has historically been between 150 and 200 basis points. The only reason mortgage rates have been so low is that the federal government is fully backing Fannie Mae and Freddie Mac's purchases and insuring of conforming mortgages that banks have been making. If not for Fannie (FNM) and Freddie (FRE), banks would be charging home buyers much higher rates and would be required to keep the loans on their own books, says John Burns, a real estate consultant in Irvine, Calif. who advises the major homebuilders.

"The rise in interest rates is coming at a really inopportune time, just as the stimulus was taking effect," says Mark Zandi, chief economist at Moody's Economy.com. "It will hurt the housing market. It dilutes the benefit of the tax credit" to first-time home buyers.

With much of the weakness in the banking system having been addressed, Zandi believes the housing market is becoming the primary risk to the economy. But he also believes the bond market has gotten ahead of itself in anticipating a return of inflationary pressures. It makes sense, however.