When rates rise, some people win

By

America is entering that edgy season where financial markets and economists are trying to figure out when interest rates will go up.

June? After the November election? It's a huge guessing game that's especially intense now because interest rates have been at historic lows and are already rising a bit.

But step off that speculation merry-go-round, and the big question isn't when, but who wins and loses from higher rates. Perhaps some people can shift their resources to minimize the effect of being in the wrong category.

Recommended: Default

Already, signs of a bustling economy and the assumption that the Federal Reserve, as a result, will sometime later this year boost interest rates have prompted financial markets to raise rates in advance.

The yield on a 10-year Treasury bond is up about half a percentage point in the past month to approximately 4.4 percent. It was 3.1 percent last June.

The Mortgage Bankers Association reports that in just the week ending April 16, the average contract interest rate for 30-year fixed-rate mortgages increased to 5.84 percent from 5.77 percent a week earlier; a one-year adjustable rate mortgage (ARM) rose to 3.58 percent from 3.53 percent.

What these changes suggest is that the risks of owing money are going up. In general, higher interest rates favor the people who have money to loan - creditors - at least eventually. Contrariwise, they can batter debtors - often the "common man" - with rising interest costs.

One obvious loser is the new homeowner. She or he will have to pay more on a mortgage. Some would-be buyers will be shut out of the housing market altogether.

Homeowners with ARMs would also see their monthly bills rise eventually, depending on their contract. Mortgage refinancing activity has declined by half from a year ago. The costs of refinancing exceed potential savings for more homeowners.

The slowdown in refinancing could also hurt affiliated industries, such as home repair, in coming months.

There are other winners and losers. Buyers of a new car or a major appliance can expect to find fewer financing options with bargain interest rates. People with credit-card debt could also lose out. Although interest rates on credit cards are usually slow to adjust, they will move up if the prime rate of commercial banks rises.

Businesses also will have to pay more on loans. So will the federal and other governments as they refinance debt.

But higher rates boosts the fortunes of some.

People heavily invested in bonds could see the paper value of the portfolio go down as interest rates rise, but not the return. As portfolios turn over, they could get a higher yield. Bank certificates of deposit will pay more when renewed.

And to the extent that rising rates mirror a stronger economy, with more jobs and more prosperity, consumers would benefit. Extra government spending and tax cuts helped lift the US and world economy out of a slump.

Unfortunately, that strategy generated deficits that may push interest rates even higher.

Consider this: After 9/11, the United States experienced the largest deterioration in the federal budget in a short time span since World War II.

Sustained and large deficits now threaten to raise interest rates worldwide, say economists at the International Monetary Fund (IMF), a multilateral watchdog institution. That's because government borrowing reduces the amount of money available for private loans. In turn, those higher rates and deficit- reduced savings will hurt investment and productivity and make economies grow slower.

This view is somewhat controversial among economists.

"The impact of deficits on US interest rates is tenuous at best," says Bank of America economist Mickey Levy in New York.

That's right, says Peter Orszag, an economist at the Brookings Institution in Washington. The US currently has both huge deficits and low interest rates. But projected deficits - deficits seen as going years into the future like those now anticipated in Washington - do have an impact on current long-term rates.

Mr. Orszag figures that the current deficit, now running at 3.5 percent of GDP, will raise interest rates between 1 and 2 percentage points.

The direction of interest rates is of keen interest to Lacy Hunt, an economist at Hoisington Investment Management Co. in Austin, Texas.

"We have a lot at stake here," he says. Hoisington manages $3.6 billion in investor money, most of it in long-term bonds. It is not hedged. If rates go up, the price of those bonds falls immediately.

But Mr. Hunt takes the "extreme minority view" that the economic outlook is far more fragile than the IMF or the Federal Reserve assume. The fiscal stimulus from the Bush tax cuts ends in a few weeks, he says. Less mortgage refinancing and higher oil prices will hurt the economy. The previous four "oil shocks" since 1970 were followed by recessions, he notes. And consumer spending is endangered by record debt levels and almost no growth in wage and salary income.

In addition, the nation's money supply has been growing at its slowest rate in seven years - 4 percent over the past 12 months, says Hunt. That implies slower growth ahead.

Most economists, however, are much more cheerful.

They figure the economy, with more job growth, will easily thrive in the months ahead, despite higher interest rates.

But maybe not the stock market.

When interest rates rise, investment in bonds becomes relatively more attractive. Money can shift from stocks to bonds, depressing stock prices, notes Orszag.

Share this story:

We want to hear, did we miss an angle we should have covered? Should we come back to this topic? Or just give us a rating for this story. We want to hear from you.

Loading...

Loading...

Loading...