Should You Be Worried About Rising Interest Rates?

Interest rates on U.S. Treasuries and mortgages are rising. What does it mean and what should you do?
Interest rates have spiked sharply higher in recent weeks on the news that the Federal Reserve is considering a “taper” of its long running quantitative easing program.

Thirty Year interest rates on U.S. Treasuries have spiked to the highest level in more than a year, while 10 year notes (NYSEARCA:IEF) have also climbed. Mortgages rate recently broke the 4% level, up from 3.5% in early May. This could put an immediate break on the housing industry (NYSEARCA:XHB), which has been one of the bright spots in a mediocre economic recovery to date.

The recent higher mortgage interest rates have hit the mortgage refinancing industry hard and put a damper on new loan applications, as well.

30 Year U.S. Treasury rates are now 3.37%, up from 2.5% at the beginning of 2012. Prices of U.S. 30 Year Treasuries have dropped dramatically in the last month, as evidenced by the chart of iShares 30+ Year Bond Fund ETF (NYSEARCA:TLT) below:


In the iShares 30+ Year Bond ETF (NYSEARCA:TLT) chart, we can see how the price of the long bond has declined 8.5% and is in a bear market, below its 50 and 200 day moving averages. This is a dramatic move for what is normally a very stable and long term trending market. Investors need to consider what the recent rise in interest rates means for their portfolios and for the broader U.S. stock market. (NYSEARCA:DIA) Rising interest rates have the potential to be extremely destructive for the U.S. stock market (NYSEARCA:SPY) and economy.

Here’s why:

1. Rising interest rates will make bonds more attractive and stocks less, putting downward pressure on stock prices. Much of the recent “Great Rotation” from fixed income investments to stocks and the recent market rally has been the search for yield in a zero interest rate environment. Rising rates will offer more competition for the stock market.

2. Rising interest rates typically increase the cost of doing business for U.S. corporations. Rising costs reduce profits, which in turn reduce price/earnings ratios which reduce stock prices.

3. The U.S. government currently has a crushing debt load of $17 Trillion, much of which is in short term notes. If interest rates rise, payments on the national debt will do the same and will most likely be added to the deficit. This leads to a vicious circle of declining credit ratings and higher interest rates as seen recently in Greece, Spain, Portugal and Ireland.

4. Rising interest rates could very likely pop the bond market bubble that has formed in recent years, as money fled the stock market for the safety of U.S. Treasuries. Investors could be faced with declining values in their bond portfolios and, if forced to sell before maturity, could endure realized losses.

The United States currently finds itself in a situation in which it is the world’s largest debtor, with $17 Trillion in debt, a number larger than the country’s GDP. The debt is so huge that most analysts say that it will be impossible for the country to ever pay it off. Therefore, investors in U.S. Treasuries are betting that the “full faith and credit” of the United States will protect their investment since the country’s cash flow won’t.

Since the onset of the financial crisis in 2007, the Federal Reserve has tried to control interest rates, so far successfully, with its zero interest rate policy and quantitative easing programs. Should the Fed lose control of interest rates or should the rates continue their recent sharp rise, the U.S. economy and stock market will be faced with significant dangers and the potential for sharp declines.

Bottom line: The U.S. economy and stock market have become addicted to easy money and low interest rates. A change in this environment will be traumatic for U.S. and global financial markets. Investors need to keep a close eye on this situation, and react accordingly. Every market environment presents profit opportunities but they will likely be different in the future if interest rates continue their climb.

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