Interest Rates Trending Upward

U.S. interest rates have reversed course and are now trending upward

 6/10/15

Interest rates have been a hot topic of discussion recently. Will the Federal Reserve raise short-term rates? If they do, will it be in September or October? If short-term rates rise will long-term rates follow? The market has finally weighed in on the debate and it appears that interest rates may be going higher.   

The shift in rates is evidenced by the change in the 10 year U.S. Treasury bond yield which is often used as a benchmark for interest rates. After increasing significantly in 2013, from 1.4% in May of 2013 to approximately 3% by year-end, rates reversed. For most of 2014 and early 2015 interest rates fell, reaching a low of 1.7% in February of this year. Since February, however, the downward trend in interest rates has reversed with the 10 year Treasury yield increasing to 2.4%. 

With interest rates recent move upward through the 2.25% level, which marked their December. March, and May highs, we can officially say that the trend has revered and rates are now in an upward trend. Should this upward trend continue, there may be a  number  of implications for the markets and the economy. These include:

• Rising interest rates typically cause bond values to decline. In general, the longer-term the bond and the lower the interest rate that it pays, the greater the expected decline. Therefore, it is advisable to reduce long-term bond holdings and purchase short-term bonds when interest rates increase.

• Higher rates make borrowing more expensive which can decrease the pace of business investment and consumer spending. Both business investment and consumer spending are components of economic growth, so rising rates may cause the economic growth rate to fall.

• When interest rates increase in one country, but not others, the higher interest rate country may attract investment dollars from the lower interest rate countries. This can cause the value of the higher interest rate country’s currency to increase.

• Higher interest rates can be a positive or a negative for the different interest rate sensitive sectors of the stock market. Typically sectors that pay high dividend yields or borrow large amounts of money, such as the utilities or real estate sector, may suffer while financials my benefit due to higher returns on loans.

• Higher interest rates can be a negative for the real estate market as most real estate is financed. Therefore, higher interest rates make the total cost of buying higher which may price some buyers out of the market.

• The federal government, as well as many state and local government, have borrowed large sums in the past decade. Higher interest rates may make this debt more expensive to service causing government deficits to increase and government spending to decrease.

So far, interest rates are still low by historical standards. However, if the current upward trend take hold and rates increase to the levels of late 2013 or higher it could have a major impact on the financial markets and the U.S. economy.