Big bounce in interest rates: why no one should hit the panic button

The cost of a loan has gone up significantly since early May, affecting both the housing market and investors. But interest rates are still low, and experts say their rise shouldn't cause panic.

Whether you’re buying a home or borrowing for your business, the cost of a loan has gone up significantly since the beginning of May.

The speed of this change has roiled the housing market and rattled investors. Many view it as the beginning of the end for the era of “easy money” from the Federal Reserve. But it’s not so easy to define what the shift means. Is it good or bad for the economy? Could it spoil the housing recovery? Should investors sell bonds?

Many financial experts say the jump in interest rates isn’t something to ignore but also shouldn’t be taken as a cause of knee-jerk panic.

First, the basic facts.

Since May, long-term interest rates have risen as investors have revised their expectations about the Federal Reserve. The Fed still hasn’t raised its short-term benchmark interest rate from its extraordinary near-zero level. But Fed officials have been signaling that they expect to “taper,” eventually, their policies of unusual monetary stimulus.

So the view on Wall Street is that the central bank’s short-term interest rate could rise to about 1 percent by two years from now. The result: The annual yield on a 10-year Treasury note surged from 1.66 percent as of May 1 to 2.65 percent on July 8. In effect, the gap between those numbers means that the US government’s cost of borrowing just went up by about 60 percent.

That’s tough on US taxpayers. And the change in Treasury rates ripples into other financial markets. The cost of home-mortgage loans, issuing top-quality corporate debt, and other forms of borrowing has also jumped.

For the economy, the bad news is that this comes at a time of already weak global growth.

“The rise in market interest rates … could seriously jeopardize even the tepid pace of the US recovery while intensifying Europe’s recession and throwing China into a sharper slowdown,” writes John Makin, an economist at the conservative American Enterprise Institute.

He notes that the rise in rates isn’t fueled by an expected rise in inflation. So borrowing costs more in “real” (inflation-adjusted) terms.

Others see a silver lining in the recent interest-rate jump: Despite a tumultuous June, US stock prices recovered in early July to approach the highs seen in May. That reflects investor expectations that the economy can keep growing despite the new credit climate.

And the Fed appears unlikely to embark on any monetary tightening if economic growth falters.

Many forecasters predict that the housing market can weather the new environment for loans. To some extent, rising rates are a nudge for would-be buyers to act – as they seek to lock in deals before rates keep edging higher. And in housing, as elsewhere in the economy, real interest rates are still very low by historical standards.

For investors in bonds and bond mutual funds, though, rising rates mean trouble. When rates on newly issued bonds are rising, it means prices of bonds that are already in investor portfolios go down.

Some bond investors have been bailing out, based on the view that there’s more mayhem ahead. But it’s a tough choice, for a few reasons.

A key reason many people hold bonds is to offset the risk inherent in holding stocks – a theory that argues against shifting bond money into stocks. Money-market funds, as an alternative, have their own problem: a negative real yield.

And there’s no guarantee of how long, or by how much, bond prices will keep falling. (Market analysts at Bank of America Merrill Lynch predict that the 10-year Treasury yield will hit 3 percent by the end of this year, and 4 percent by the end of 2014.)