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Rising rates: Reason to worry or sign of strength?

Monday - 6/3/2013, 12:00am  ET

MATTHEW CRAFT
AP Business Writer

NEW YORK (AP) -- The trends sound ominous. Mortgages get more expensive and both big companies and the federal government pay more to borrow. The stock market dips on suspicions that the Federal Reserve could start pulling its support for the economy this year.

The thing is, these current trends fall under the heading "good news."

How so? Because record-low interest rates are a legacy of the financial crisis. And as long as they disappear gradually, many in the financial world will be happy to see them go.

"It will mean we're in a healthier economy," says J. J. Kinahan, chief strategist at TD Ameritrade.

Encouraging reports on housing and hiring, along with a soaring stock market, have led many to suspect that the Fed could cut back on its bond buying in the coming months. That's the main reason traders have been selling bonds over recent weeks, driving down prices and lifting the 10-year Treasury yield to its highest level of the year on Wednesday -- 2.23 percent.

When the Fed makes a move, many investors probably won't consider it a vote of confidence for the economy. Some believe the stock market could plunge without the Fed's support. Others are likely to move money out of the market because they're unsure about how everybody else will react.

"Maybe it's bad for the stock market in the short term," Kinahan says, "but it's probably good for housing, manufacturing and hiring. It will be better for everybody overall."

For those who think the economy remains fragile, the prospect of higher rates still stirs up fears. They worry that rising interest rates will derail the choppy economic recovery.

The Organization for Economic Cooperation and Development warned of the dangers in a report Wednesday. The OECD estimates that a jump of 2 percentage points in long-term interest rates could sink the stock market, drive down home prices and hurt companies by pushing the value of the dollar up.

But there are plenty of reasons to think none of that will play out as interest rates edge higher.

One problem with these forecasts of disaster is that they rely on the past, and history can be a misleading guide. Before the Great Recession, rising rates usually followed a stretch of rapid economic growth or surging inflation.

The OECD's report, for instance, looked at the U.S. economy in 1994, a horrible year for the bond market but not so bad for the economy. Alan Greenspan raised the Fed's benchmark short-term rate from 3.25 percent to 5.5 percent in nine months. That sharp hike upended the bond market, cost investors billions and helped push Orange County, Calif., into bankruptcy

Such a jump in interest rates might be expected to throw an economy into recession, but in 1994 the economy had "strong underlying momentum," the OECD report says. The unemployment rate actually dropped that year, from 6.6 percent to 5.5 percent.

"This is definitely not 1994," says Mark Luschini, chief investment strategist at Janney Montgomery Scott. Back then, Greenspan's rate hikes came as a shock, he said.

By contrast, the Federal Reserve under Ben Bernanke has stressed the need to give markets plenty of notice before making a move. And interest rates today remain close to historic lows. The Fed's short-term rate is near zero.

"You have to look at the big picture," says Guy Cecala, head of Inside Mortgage Finance, an industry publication. "Historically low rates are generally a sign of a weak economy. When things improve rates should rise noticeably."

The average rate for a 30-year mortgage hit 3.81 percent this past week, the highest in a year, according to Freddie Mac. Cecala thinks there's a good chance it will cross above 4 percent in the coming months without causing any trouble for the housing market. Record-low rates have supported sales, he argues, but what really brought the housing market back to life was a growing confidence among prospective buyers that they weren't about to lose their job.

"You had to have comfort in your job and know you had employment ahead of you" before buying a house, Cecala says.

Some investors have argued that the bond market is a bubble, ready to pop when the Fed steps away. Everyday investors have much at stake, putting $1.3 trillion into bond funds since 2009, according to Strategic Insight, a firm which tracks mutual funds.

It's a prediction that people have been making for years, says Catherine Gordon, who heads a research team at the mutual-fund giant Vanguard. Warnings of a bond bubble started shortly after the Fed began buying bonds in late 2008. With inflation low, Gordon sees nothing to suggest it is any closer to coming true.

Even so, any increase in long-term interest rates pushes bond prices lower. Her advice? Sit tight. Years may pass, but higher interest rates will eventually compensate for a bond fund's losses, she says.

"Don't try to time the market," Gordon says. "It's better not to worry about what your bonds or stocks are going to do next month or next year."


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