Thursday, April 15, 2010

Fears Growing For Potential Interest Rate Spike

An increase in interest rates poses the greatest danger to the vulnerable economy and housing market. Economists suggest that interest rate increases are inevitable due to skyrocketing government debt, and would translate into significantly higher home ownership costs. See the following post from Expected Returns.

Rising interest rates will provide the knockout punch to an economy vulnerable to shocks. For over a generation, Americans have come to rely on low interest rates to fund lavish lifestyles hardly justified by economic fundamentals. Unfortunately, the secular bull market in bonds is coming to an abrupt halt, meaning American consumers are going to feel the pinch. From the New York Times, Interest Rates Have Nowhere to Go but Up:

Even as prospects for the American economy brighten, consumers are about to face a new financial burden: a sustained period of rising interest rates.

That, economists say, is the inevitable outcome of the nation’s ballooning debt and the renewed prospect of inflation as the economy recovers from the depths of the recent recession.

The shift is sure to come as a shock to consumers whose spending habits were shaped by a historic 30-year decline in the cost of borrowing.

“Americans have assumed the roller coaster goes one way,” said Bill Gross, whose investment firm, Pimco, has taken part in a broad sell-off of government debt, which has pushed up interest rates. “It’s been a great thrill as rates descended, but now we face an extended climb.”

Nine months ago, United States government debt accounted for half of the assets in Mr. Gross’s flagship fund, Pimco Total Return. That has shrunk to 30 percent now — the lowest ever in the fund’s 23-year history — as Mr. Gross has sold American bonds in favor of debt from Europe, particularly Germany, as well as from developing countries like Brazil.
It is a bearish sign when Bill Gross, manager of over $1 trillion dollars at PIMCO, turns from bull to bear on government bonds, since he has been able to consistently finesse his way into profiting from this crisis. Now that the government is easing off on its support of bonds, PIMCO is understandably taking a bearish stance. Look for large institutions to follow the lead of the man known on the Street as the "bond king."

The low interest environment of the Greenspan years truly acted as mana from heaven for consumers faced with stagnant real wage growth. Our debt-based economic model has allowed our economy to stagger along due to an accommodating Fed and the foreign purchases of our government debt. Since the Fed can't being interest rates any lower and China is running a trade deficit, both these trends are going to reverse.

The chart below shows just how much household debt outpaced income growth the past decade. Make no mistake about it, the inevitable rise in interest rates will crush the American consumer.

Housing Market Meltdown
The impact of higher rates is likely to be felt first in the housing market, which has only recently begun to rebound from a deep slump. The rate for a 30-year fixed rate mortgage has risen half a point since December, hitting 5.31 last week, the highest level since last summer.

Along with the sell-off in bonds, the Federal Reserve has halted its emergency $1.25 trillion program to buy mortgage debt, placing even more upward pressure on rates.

“Mortgage rates are unlikely to go lower than they are now, and if they go higher, we’re likely to see a reversal of the gains in the housing market,” said Christopher J. Mayer, a professor of finance and economics at Columbia Business School. “It’s a really big risk.”

Each increase of 1 percentage point in rates adds as much as 19 percent to the total cost of a home, according to Mr. Mayer.

The Mortgage Bankers Association expects the rise to continue, with the 30-year mortgage rate going to 5.5 percent by late summer and as high as 6 percent by the end of the year.
The housing market is so critical because it affects the lives of nearly everyone. Remember, it was housing that first started showing cracks before the stock market and broader economy followed suit.

Rents continue to fall in a sign that housing prices will be coming back down. Robert Shiller, founder of the Case-Shiller Housing Index, is also bearish on housing. In all likelihood, home prices will come back down after putting in a temporary bottom last year.

Credit Cards, Auto Loans

Another area in which higher rates are likely to affect consumers is credit card use. And last week, the Federal Reserve reported that the average interest rate on credit cards reached 14.26 percent in February, the highest since 2001. That is up from 12.03 percent when rates bottomed in the fourth quarter of 2008 — a jump that amounts to about $200 a year in additional interest payments for the typical American household.

With losses from credit card defaults rising and with capital to back credit cards harder to come by, issuers are likely to increase rates to 16 or 17 percent by the fall, according to Dennis Moroney, a research director at the TowerGroup, a financial research company.

“The banks don’t have a lot of pricing options,” Mr. Moroney said. “They’re targeting people who carry a balance from month to month.”

Similarly, many car loans have already become significantly more expensive, with rates at auto finance companies rising to 4.72 percent in February from 3.26 percent in December, according to the Federal Reserve.
Rising bond rates cascade down to ever facet of financing, including credit cards and car loans. Americans are feeling the dual shocks of contracting consumer credit and rising interest rates for loan balances. The factors keeping consumers afloat- early tax returns, extended unemployment benefits, record food stamp usage, and strategic mortgage loan defaults- don't point to a sustained economic recovery.

Interest rates are so critical in our debt-ladened economy that you can expect out leaders to do everything in their power to keep rates subdued. While the Fed has been relatively successful at lowering rates, albeit at the expense of $1,160 dollar gold and parity with the Canadian dollar, sooner or later the Fed will lose control. When interest rates start their meteoric rise, the "double-dip" will become a reality.

This post has been republished from Moses Kim's blog, Expected Returns.

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