How higher long-term interest rates affects you

Posted by admin on June 3, 2009 in Investment Information

Depending on what side of the fence you sit on, the recent spike of the benchmark 10 year treasury yield from as low as 2.23% in mid-January to 3.71% last week is either a good thing or a bad thing. The spike has been very rapid. On May 19, I wrote about investing in a low-interest environment when the 10 year yield was at 3.25%. On May 27, it peaked at 3.71%. While the low-interest investing environment may remain short-term (the 1 year treasury yields have not fundamental changed since the beginning of the year), the widening spread between short term and long term yields suggests, if this is sustained, that a shift is beginning to occur in the investment environment.

For some, an increase in long-term interest rates either means the economy is improving as people move out of safe fixed income instruments or the market is now factoring in inflation long term and adjusting accordingly or the U.S. economy is in real shambles and the market is putting a risk premium on purchasing government debt. As usual, ask any two economist a question and you will get three answers.

More to the point though, if long term interest rates continue to rise, how will this affect you and I?

Bye, bye cheap mortgages? Given that 10 year treasury yields and mortgage rates tend to correlate, the era of the dirt cheap mortgage could be soon ending. As the Wall Street Journal reported, 30 year mortgage rates have jumped from 4.75% to 5.25% which is low historically but relatively high given recent history. This poses question whether those with adjustable rate mortgages should turn their mind towards the “to lock in or not lock in” debate.
Pay down long term debt. Along with mortgages, credit card and line of credit interest rates also tend to move in tandem with long term interest rates. If you believe long term interest rates are coming, it may be prudent to prioritize between going back into the market vs. paying down all long term debt.
Increased taxes. It is difficult for governments to move from deficits to balanced books and surpluses not only because of the political obstacles to cutting services but the carrying costs of incurring large deficits tends to prolong the recovery time. If interest rates continue to rise and the deficits continue to be historically large, governments could be quickly forced to raise taxes or slash services which, in light of the fact governments are becoming everyone’s benefactor, does not appear as likely.

If the rise in long-term interest rates is merely a prelude to an inflationary environment, then break out the usual inflationary instruments: real return bonds/TIPS, dividend-paying stocks, real estate and gold (still subject to continued debate as to the utility of the investment).

Federal Reserve Chair Ben Bernanke testifies in front of Congress today. I am sure the topic of higher long term interest rates will be raised. It will be interesting to see why he thinks this is happening and what the Federal Reserve will do or not do about this issue.

1 Comment on How higher long-term interest rates affects you

By Canadian Capitalist on June 3, 2009 at 11:00 am

Thanks for the mention. Fortunately, VRM are becoming cheaper and the premium over prime is dropping. Unfortunately, as you’ve noted here, the fixed-rate mortgages are going up.

Fortunately, we Canadians should be relatively okay if inflation breaks out as we are still primarily hewers of wood and drawers of water and our benchmark has a very high commodity exposure.

The only asset class missing in my portfolio is RRBs. It would be nice to get a yield of 2.5% real, so my wait continues.