How higher interest rates touch consumers, firms, investors
WASHINGTON -- All it took was speculation that the Federal Reserve could slow its bond buying months from now -- and then a few words Wednesday from Chairman Ben Bernanke to confirm it.
The result is that record-low interest rates, which have fueled economic growth, cheered the stock market, shrunk mortgage rates but punished savers, are headed up. And once the Fed starts scaling back its bond purchases, those trends could accelerate.
It means home loans are starting to cost more. Corporations will pay more to borrow. Bond investors are being squeezed. The stock market is plunging.
The yield on the 10-year Treasury note, a benchmark for long-term mortgage rates and other loans, hit 2.43 percent Thursday. As recently as May 3, it was 1.63 percent.
For now, mortgage rates remain extremely low by historical standards. Economists say rates might not rise much further unless the economy strengthens significantly.
And the fact that Bernanke and the Fed think the economy is healthier represents a critical dose of confidence. Slightly higher rates may spook stock and bond traders. But in the long run, a robust economy should sustain the housing rebound, support job growth and encourage businesses to borrow, even at somewhat higher rates.
More economic growth should ultimately boost stock prices, too. Long-term investors saving for retirement, college educations and other major costs stand to benefit.
The Fed's $85 billion-a-month in bond purchases have helped keep long-term rates down. Bernanke said he expects the Fed to stop buying bonds altogether by the middle of 2014 if it feels the economy can manage without that stimulus. He stressed, though, that if the economy weakens, the Fed won't hesitate to step up its bond purchases again.
Here's how higher rates will affect consumers, businesses, investors and other players.
The main impact on consumers will likely be higher mortgage rates. Rates on auto loans, student loans and credit cards probably won't rise much soon. They're more closely tied to the short-term rate the Fed controls. That rate isn't expected to rise before 2015.
The average rate on a 30-year mortgage jumped from a record low of 3.31 percent in November to 3.98 percent last week, according to mortgage giant Freddie Mac. That's the highest point in more than a year.
Mortgage applications fell 3.3 percent last week, according to the Mortgage Bankers Association, though they're still up from their level a year ago.
But economists say the housing recovery can withstand higher rates. Sales of previously occupied homes topped 5 million in May for the first time in 3½ years.
Steady job gains and solid consumer confidence should fuel sales in coming months, even if rates are higher.
"It's that improving economy that's bringing people back into the housing market," said Greg McBride, senior financial analyst at Bankrate.com. "The recent rise in mortgage rates does not negate that."
The biggest barrier for many homebuyers has been difficulty obtaining a mortgage. Banks have tightened lending standards since the financial crisis erupted in 2008. Higher loan rates would allow banks to make more from mortgage lending and could lead them to lend more freely.
"The irony is that higher rates are likely to mean more people can get mortgages," said Joseph LaVorgna, chief U.S. economist at Deutsche Bank.
Higher rates generally benefit those with much of their money in savings. They can earn more on bond investments, CDs and savings accounts.
But savers aren't likely to enjoy much benefit soon. Banks already have plenty of deposits, McBride said. They don't need to boost rates on CDs or bank accounts to attract more cash.
"They're having trouble lending out the deposits they have," he said.
The rate on the 10-year note, for example, is still historically low and may not outpace inflation over the next decade. A 10-year Treasury yielding 2.4 percent "is still a bad deal," McBride said.
Ordinary investors who have soured on stocks have poured about $1 trillion into bond funds since the Great Recession began in December 2007. A common assumption is that bonds aren't very risky. These investors might be having second thoughts.
That's because as rates rise, bond investors can lose principal as the value of their existing bonds declines. Investors in bond funds, especially those with longer-term holdings, are most at risk. The Pimco Total Return fund, the world's largest mutual fund with $285 billion in assets, has lost 3.3 percent in the past month.
Marilyn Cohen, president of Envision Capital, fears that Baby Boomers will pull out of bond funds as fast as they rushed into them. If so, that could send bond yields rising further in a cycle of selling spurring more selling.
"The group that stampeded out of stocks into bond funds is going to have a challenging year," she said.
Higher mortgage rates could lower demand for new homes. That would squeeze builders. The stocks of leading builders such as Toll Brothers, Lennar and D.R. Horton all plunged Thursday far more than the stock market as a whole.
But many builders say they remain optimistic. They say higher rates will encourage potential buyers to get into the market before rates rise further.
"We're trying to encourage buyers to get off the fence, so we think it will actually help sales," said Holly Haener, director of sales and marketing at CBH Homes in Meridian, Ohio.
Eventually, if mortgage rates keep increasing, some buyers would no longer be able to afford a home, Haener acknowledges. They might have to buy a smaller house or forgo some home amenities to offset the cost of a higher mortgage rate.
Higher rates could further depress loan demand at many small businesses, at least in the short run.
But higher rates can also benefit small business because they signal that the economy is strengthening. Once companies make more money because they have more customers, they're more inclined to expand or buy equipment even though financing is costlier.
Bella Bag, a retailer of designer handbags and other accessories based in Atlanta, is borrowing for the first time in its eight-year history. Chief financial officer Brian Froehling said the company decided to do so now because it thinks rates will rise.
Steadily higher rates might give the company pause before it borrows again, Froehling said. But it's hired four staffers this year in response to growing demand. It will likely fare well even if rates rise further, he said.
Large U.S. companies have sold more than $4 trillion in bonds to investors in the past 2½ years, according to Dealogic, a research firm. That's more than the economies of every country in the world except the United States, China and Japan.
The biggest sale ever was Apple's offering of $17 billion in bonds in April.
As rates began rising last month, new sales slowed. Companies with top credit ratings sold only $9.5 billion in bonds last week, according to Dealogic -- 60 percent less than the average for each week through April this year.
Still, companies have been collecting record profits. That means they should still be able to expand their businesses and hire more, even if borrowing costs rise.
Rising rates are a relief for companies with employee pensions. Accounting rules require them to use bond rates to determine how much money to set aside so they'll be able to pay retiree benefits in the future.
When rates are low, rules require companies to set aside more money because their bond holdings produce little interest. Conversely, higher rates help: Companies can earn more on their bonds, so they don't have to invest as much.
A small increase in rates can produce big savings. The Pension Benefit Guaranty Corporation, a government agency that takes over troubled company pensions, must pay $110 billion in future benefits. It estimates that a 1 percentage point rise in rates would reduce the amount it needs to invest today by 10 percent, or $11 billion.
The federal government -- the nation's biggest borrower, with a $17 trillion debt -- might have the most to lose from higher rates. The super-low rates of the past few years have given the government a break at a time when the annual deficit was soaring.
After four years of $1 trillion-plus deficits, the nonpartisan Congressional Budget Office has forecast that the deficit will shrink to $642 billion this year. That would be down from $1.09 trillion in the 2012 budget year.
The CBO factored higher rates into its forecasts. But some economists say it might not have anticipated how high rates might go. The 10-year Treasury averaged 1.8 percent last year. The CBO expects it to average 2.1 percent this year, 2.7 percent in 2014 and keep rising to 4 percent by 2018.
Sung Won Sohn, an economics professor at the Martin Smith School of Business at California State University, said those projections now look low. Still, Sohn said other trends could offset the rate rise.
"On balance, a stronger economy generating more tax revenue will be far more beneficial than the higher cost of debt," he said.Last year, the government paid $220 billion in payments on the publicly held part of its debt. The CBO thinks that figure will be only slightly higher this year but will more than double by 2018.