In a shift, interest rates are on the rise
Economy • Prospect of higher borrowing costs sends markets into a spin.
Published: June 12, 2013 09:49PM
Updated: June 12, 2013 09:49PM
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(AP Photo/Manuel Balce Ceneta) Since the financial crisis of 2008, the Fed has taken steps to reduce rates, in an effort to stimulate borrowing and economic growth. Recently, though, Fed Chairman Ben Bernanke signaled that the central bank could scale back its efforts.

It has been a reliable fact of life for investors, corporations and ordinary borrowers — interest rates that, for the most part, keep heading lower.

But all of that may be about to change. For prospective homeowners, the cost of mortgages has been going up in recent weeks. Governments are also facing the prospect of higher borrowing costs down the road, and they are projecting increases to their debt burdens. Savers with money in bank accounts, on the other hand, have the prospect of finally earning more than a pittance on their deposits.

The interest rate charged by lenders, often cited as the single-most-important factor behind economic decisions, has been steadily going down for the most part since the early 1980s, and has fallen to historic lows since the financial crisis. Over the past few months, though, investors and banks have been demanding higher payments for their loans, pushing up interest rates and bond yields.

The first tremors have been felt most sharply on investments products that were reliant on low rates, such as bonds issued by American companies. But it is quickly spreading out into the real economy.

“I think you all should be ready, because rates are going to go up,” Jamie Dimon, the CEO of JPMorgan Chase, told a financial industry conference at the Waldorf-Astoria Hotel in Manhattan earlier this week.

As investors brace for a new era of higher interest rates, global markets in bonds, currencies and stocks have experienced spasms of turmoil. On Tuesday, the catalyst for the market’s volatility was disappointment over the Bank of Japan’s decision not to take new steps to address rising bond yields. That heightened worries that other central banks — the Federal Reserve in particular — will soon pull back on pumping money into the financial system.

Since the financial crisis of 2008, the Fed has taken unprecedented steps to reduce rates, in an effort to stimulate borrowing and economic growth and bring down the unemployment rate. Recently, though, Fed Chairman Ben Bernanke signaled that the central bank could scale back its efforts in coming months if the economy improved. But there is much debate on Wall Street over what Bernanke is planning and when it might take shape.

Several prominent money managers say they believe that the economic recovery is weakening, which will make it impossible for Bernanke to pare the central bank’s intervention and could lead rates to fall again. Interest rates have experienced temporary spikes at a number of times in recent decades before heading back down.

But a number of economic data, including last Friday’s job report, suggest that the economy is slowly recovering.

In anticipation of what the Fed may do, many on Wall Street have been preparing their portfolios for a future in which interest rates do not remain at the low levels of the past few years. In a survey of 500 large investors, 43 percent said they were planning to cut back on their exposure to bonds this year, while only 16 percent were planning to increase it, according to the asset manager Natixis.

The recent efforts to adjust to higher bond yields have already been messy. Investors have been piling out of supposedly safe bond funds that have been a source of reliable returns in recent years, creating unexpected volatility in the markets.

Big American asset managers who borrowed money in order to buy foreign stocks and bonds have recently been selling those holdings, hurting markets around the world. That has been exacerbated by data suggesting that economic growth may be slowing outside the United States.

The realignment in the markets was evident earlier this week as Asian and European stock markets fell. In the United States, stocks swung widely. Treasury prices fell, pushing the yield on the benchmark 10-year Treasury note as high as 2.29 percent — its highest level since April 2012 — before settling at 2.19 percent. The Japanese yen strengthened 2.8 percent against the dollar.

Many market specialists think that a transition could go more smoothly in the long run if interest rates continue to rise as the U.S. economy grows. Still, even in that optimistic situation, an array of market participants will have to shift their operating procedures and assumptions from a world where declining interest rates were a given.

“When past performance has been so consistent, the risk that investors underestimate the risk, I think has consistently been an issue,” said Richard Ketchum, the president of the Financial Industry Regulatory Authority, which oversees brokers.

The recent market volatility highlights the connection between Wall Street investors and consumers. Take the mortgage market. Banks set mortgage rates in line with the yields on mortgage-backed bonds. So as a sell-off has hit the market for such bonds, causing their yields to rise, ordinary borrowers end up paying more.

The rising cost of a new mortgage has already pushed down the number of people refinancing old mortgages, putting a crimp on a recent source of extra income for many households.

The looming question now is whether higher mortgage rates could stall the rally in home prices that has been taking place across the country.

Many real estate analysts say that homes are so affordable that even a considerable rise in interest rates would not do much to undermine the housing recovery, especially if the economy is growing at a healthy rate.

But Joshua Rosner, a managing director at the research company Graham Fisher & Co., said many Americans were still so heavily indebted that even a small rise in mortgage rates would hit the housing market. “Affordability is already a problem and rising rates won’t help that,” he said.

For governments around the world, a rise in rates will eventually push up their borrowing costs at a time when they may still be grappling with fiscal deficits. Some countries will probably be able to take a steady increase in their stride. But a jarring wave of selling has recently hit certain bond markets in Latin America and Europe, pushing up borrowing costs for governments there.

Recent market moves have also been an unpleasant jolt for ordinary savers who have come to view bonds as a stable anchor for any retirement account. The Vanguard total bond market mutual fund fell 2.7 percent last month after returning a steady 5.4 percent a year since 2008. Funds holding junk bonds, which were one of the hottest investments in recent years, have suffered even more.

Some managers argue that the important thing is to shift between different types of bonds, de-emphasizing longer lasting, government issued bonds. But whatever the mix, it is likely that bonds will present a risk to investors that they have not in recent history.

“There’s no doubt we’re living through the end of a generational bull market in bonds,” said Scott Minerd, the chief investment officer at Guggenheim Partners.

Impacts on a broad scale

For governments worldwide, a rise in rates will eventually push up their borrowing costs at a time when many are wrestling with fiscal deficits. Some will be able to take a steady increase in stride, analysts say, but a jarring wave of selling has hit certain bond markets in Latin America and Europe, pushing up borrowing costs.