Why Rising Interest Rates May Be a Good Sign

Why Rising Interest Rates May Be a Good Sign

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.”

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.

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

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

“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.”

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