Rising Rates Could Threaten Economic Growth, Stock Rally

Investors have a new worry these days: higher interest rates.

The recent surge in rates is threatening not only the housing market but the overall economic recovery and the three-month-long stock rally, experts say.

Interest rates have been climbing steadily in recent weeks as the government tries to sell billions of dollars in debt to finance the economic recovery and financial rescue efforts. The resulting selloff in Treasury prices has pushed up their yields, which influences many interest rates.

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Mortgage rates are among those that have spiked higher with the rise in the 10-year Treasury yield. A continued increase in mortgage rates could could hamper the housing rebound—considered critical for the economy to come around.

The prospect of higher interest rates already has begun to spook stock investors. Some have been taking money off the table as they wait to see how bond traders and the government react to the many dynamics influencing the debt market.

"The bond market has to stop getting routed for equities to continue going up," says Uri Landesman, head of global growth strategies at ING Investment Management in New York. "At some point rising interest rates are a problem specifically for an economy struggling to get back on track. We clearly need to see if not a turnaround in Treasury yields, at least the rise stopping."

High Treasury yields generally spell trouble for stocks, especially if those increases happen over a short period of time. The 10-year note has popped from an historic low of 2.05 percent back in November 2008 to more than 3.8 percent in Monday trading.

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In such an environment, some commodities stocks perform worse while consumer staples work the best, according to a research note Monday from Steven Desanctis, head of small-cap strategy at Bank of America-Merrill Lynch.

"Treasury yields have risen due to the fact that the market is anticipating positive economic growth in the second half of this year coupled with a concern about inflation thanks to a huge increase in supply over the next two years owing to the growing budget deficit," Desanctis wrote.

Looking at small-cap performance in the Russell 2000 during similar yield gains, consumer staples outperform by an average of 7.5 percent, financial services by 6.1 percent, utilities at 6.0 percent and health care by 4.7 percent. Energy underperforms by 2.9 percent and materials and processing by 2.3 percent.

Broadly speaking, the small-cap index is about 2 percent lower than normal when Treasury yields jump.

Treasurys have risen amid a flood of government issuance, with more on the way. At the same time, the Fed has been buying mortgage-backed securities in an effort to keep home loan interest rates low, a strategy that has worked until recently when investors slowed their buying of Treasurys.

That has raised concerns from investors over what impact the Treasurys yield move will have on housing.

The housing market had begun showing signs of recovery when the 30-year fixed mortgage rate plunged below 5 percent, triggered by government buying of loans backed by Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE).

But as the surge of Treasurys has continued, mortgage rates have popped higher, and that has put a damper on a housing recovery and investors hopes for a market turnaround.

"Housing was just starting to turn around, and higher mortgage rates, even if it's incremental—50 or 75 basis points—that can make all the difference in the world in terms of affordability," says Tom Higgins, chief economist at Payden & Rygel in Los Angeles.

Among the lingering concerns is that the Federal Reserve will react to inflation worries by tightening monetary policy, which would drive up mortgage costs even more.

Fed fund futures for December are pricing in the near certainty that the central bank will jack up its key lending rate to 0.5 percent from its current target of zero to 0.25 percent. February futures are fully pricing in even more tightening at the January Fed meeting, with the rate forecast to hit 0.825 percent.

"It's a mistake to let mortgage rates rise," Higgins says. "I think the Fed may be waiting to see what happens. They may want to see how much pain it inflicts or if the market just solves the problem itself."

In fact, Higgins thinks rates on Treasurys have peaked as the economy settles into the oft-cited "new normal" with slower growth inhibiting the threat of runaway inflation. Moreover, he thinks tightening yields among other securities such as corporate bonds, asset-backed securities and high-yield bonds also will dampen the Fed's appetite for tightening.

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Still, investors remain concerned over how bad the deficit situation will get, and uncertainty is always an enemy of stock market growth.

"Drawing conclusions for the broader equity markets is kind of tough," Higgins says. "I don't see a whole lot of upside for a Treasury market rally, because unless the impact of slowing economic growth is that it prompts the Fed to come in and start buying Treasurys, I don't think you're going to see yields rally meaningfully."

But investors worries were reflected in a market that moved sideways Friday despite a nonfarms payroll report far better than expected, followed by a sharp move lower Monday.

Indeed, part of the "new normal" may include investors walking on eggshells each time the Treasury starts selling notes, in hopes that demand is brisk enough that yields remain low but not so massive that it would indicate a run from stocks.

"Every auction is going to be a worry going forward—every one—because of the fact that we're walking this tightrope to where we don't want the people that own our bonds, the ones that buy our bonds, to stop doing it," says Michael Cohn, chief investment strategist at Atlantis Asset Management in New York, who thinks yields could hit as high as 6 percent before abating.

ING's Landesman calls the current state of affairs "key days for the market" in which he expects a trading range of 900 to 1,000 on the Standard & Poor's 500 that he thinks will be critical to maintain to establish a lasting move higher.

"What I like about this market is the floor seems continually to be getting lifted. Anytime a support level holds I think that's very good," he says. "Things are getting better. But there are still significant perils out there."

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