Now that a collapse of the U.S. banking system seems unlikely, stock-market watchers have found a new thing to worry about: rising interest rates. The yield on the government's 10-year Treasury bond is up 65% this year to a recent 3.83%. Says top Wall Street strategist Edward Yardeni, "If bond yields get up to 4.5%, so not much higher than they are now, I think we would see a real decline in mortgage refinancing, which would threaten the viability of the economic recovery." (Read "Economic Recovery: Will Corporate Profits Recoup?")
Yardeni and others are worried that higher interest rates could push housing prices lower, and hurt banking profits. What's more, rising rates could indicate that inflation, which has largely disappeared in the recession, is coming back. To be sure, the increase in borrowing costs has already slowed home-loan-refinance activity, but it is unlikely to do much else to damage the economic recovery. (See pictures of the housing crisis.)
First of all, although they seem related, historically there has been little correlation between housing prices and interest rates. Some more homeowners may be pushed into foreclosure because they can't refinance, but that is unlikely to affect whether people decide whether now is a good time again to buy a house, which is what really drives real estate prices. A 2006 study of mortgage rates and New York City housing prices going back to 1975 by Lucas Finco of Quadlet Consulting found no correlation between lower mortgage rates and higher housing prices, or vice versa. In fact, some think a modest rise in interest rates could be good for housing demand. "For the fence sitters, rising interest rates could be the motivation they need to buy," says Steven Wieting, Citigroup's US economist.
And while foreclosures are certainly bad for banks, higher interest rates alone aren't. It is not the level of interest rates that matters to bank bottom lines, but the difference between short-term rates and long-term rates. Banks make money when they can borrow money on a short-term basis think about your deposits at little costs and lend it out on a longer-term basis your mortgage at a higher rate. That's what economists call the yield curve. And the steepness of the curve, which is the difference between short-term rates and long-term rates, is what really determines how profitable banks are.
The good news is that in the past two years, the yield curve has gone from a bunny slope to a double black diamond. The difference between the 3-month Treasury bills and U.S. 10-year bond is now 3.65 percentage points. Two years ago, the difference between those two rates was a mere quarter of a point.
What's more, despite higher government-bond yields, corporations are actually paying less to borrow than they did a few months ago. As the credit crisis continues to ease, those rates could come down even further, making it cheaper for companies to borrow and expand their businesses. According to Credit Suisse, the average yield on bonds with an investment-grade rating has dropped a full percentage point to 6.2% from 7.2% at the beginning of the year. "The concern that higher interest rates will slow the recovery is prevalent among a lot of market watchers, but it is not a concern of mine," says Carl Lantz, U.S. interest-rate strategist at Credit Suisse.
Finally, rising interest rates are often a harbinger of good things to come. Yes, an uptick in interest costs can slow a galloping economy. But in recessions, like we are in now, higher interest rates usually signal better economic times ahead, not worse. For instance, the yield on the 10-year government bond rose nearly 20% in November 2001 the last month of that recession. Indeed, many economists believe the rise in interest rates now signals a return to normal, and not a sign that we are in for more trouble.
"Interest rates always rise when things are improving," says Lakshman Achuthan, managing director at the Economic Cycle Research Institute. "If higher interest rates choked off recoveries, then we would always be in recession."