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Fixed-Income Insights

How high does the yield on the 10-year Treasury note have to reach before it starts to hurt the economy and home prices? 

The $85 billion question for the markets: When do rising interest rates really start to bite? Specifically, at what juncture could a significant rise in the yield on the 10-year Treasury note start to cause problems for the U.S. economy and the housing market?

The Federal Reserve is also seeking a definitive answer to this question, which is at the crux of the successful execution and management of its tapering process. ("Tapering" refers to the anticipated reduction of the Fed's $85 billion in monthly bond purchases under its quantitative easing [QE] program.) If the central bank knows the "tipping point" of interest rates, it can manage its exit from QE without creating undue strain on financial markets—and, potentially, the next financial crisis.

The key variables in this process are 1) the timing of any further interest rate increases and 2) the underlying strength of the U.S. economy. Were the yield on the 10-year Treasury note to rise immediately an additional 100 basis points, it could indeed stall the economy, freeze the housing market, and send back the U.S. economy into recession. However, a 100 basis-point rise over the next year—especially if the economy develops self-sustaining growth—may be tolerable.

Yield Signs
The Fed already has to cope with a significant increase in interest rates since May, when the market first began to anticipate tapering. The central bank hopes that interest rate-sensitive sectors of the economy, especially housing, can adjust to the 100 basis-point rise in mortgage rates that has already taken place and that withdrawal of monetary accommodation can be gradually executed without any adverse effect on economic growth.

The market's focus on the prospect of further increases in Treasury yields is understandable, as we've already seen a measurable impact from the rise in interest rates over the past several months. According to the Mortgage Bankers Association, mortgage applications for home purchases have declined more than 20% since early May. Mortgage applications for refinancings have dropped 60% during the same period. The decline in purchasing interest has been revealed in recent weaker home sales numbers, even though prices have not adjusted downward.

The impact of a decline in refinancings is harder to isolate. To the extent that refinancings increase discretionary income and, subsequently, spending, the boost to the economy that they provided early in 2013 will not be available at current or higher mortgage rates.

Lagging Loans
The effect of higher interest rates on the broader economy is difficult to quantify. One useful approach may be to examine trends in bank lending. The gradual improvement in lending that was unfolding over the last few years seems to have slowed. According to the Fed's weekly H.8 report from November 1, total loans and leases issued by commercial banks, after declining in 2009 and 2010, rose by 1.8% in 2011 and 2.7% in 2012. In 2013, though, the uptrend has reversed: After an improvement of 3.6% in the first quarter, growth in loans and leases had fallen to only 0.6% in the third quarter.

Commercial and industrial (C&I) loans showed slightly better strength in the Fed's November 1 report, but a similar pattern. After growth of 11.3% in 2012 and 10% in the first quarter of 2013, they slowed to a 6.8% pace in the third quarter. Consumer real estate loans fared poorly. After finally turning positive in 2012 at a growth rate of 1.2%, they contracted at a 6.9% pace in the third quarter of 2013.

It's apparent that higher interest rates have affected loan demand, though this is not the only factor weighing on bank lending. The recent weakness likely is also a function of uncertainty related to slow economic growth, political dysfunction in Washington, and questions surrounding the implementation of the Affordable Care Act. We speculate that an additional rise in interest rates in this environment could be devastating—which is precisely why the Fed has postponed its tapering decision and the associated threat to higher interest rates.

Past Patterns
To try to assess the impact of an additional 100 basis-point rise in the 10-year Treasury yield, let's go to the history books. Our research shows that since 1992, there have been two instances when the 10-year Treasury yield rose at least 200 basis points within a 16-month period: September 1993 through November 1994, and September 1998 through January 2000. Both periods enjoyed stronger gross domestic product (GDP) growth preceding the rate rise, in contrast to the weak showing from the U.S. economy prior to the interest-rate rise starting in May 2013.

Stronger growth in the two previous periods could have positioned the economy to withstand higher interest rates with less consequence than the more fragile growth that characterizes the economy today. Nonetheless, in each of our historical periods, economic weakness was visible in the year following the interest-rate rise.

After the September 1993–November 1994 period, during which GDP growth averaged about 4.0% and the 10-year Treasury note yield rose about 250 basis points, the subsequent four quarters averaged growth of about 2.5%, including two periods of growth at or below 1.0%. Similarly, the September 1998–January 2000 period, when the 10-year Treasury yield rose close to 225 basis points and GDP growth averaged about 5.3%, was followed by four quarters of growth that averaged just less than 3%, including two quarters of growth at or below 1.1%. (There can be no assurance that the U.S. economy will behave in a similar manner in a future period of rising interest rates.)

And the Answer Is...
While there are myriad factors affecting GDP growth, this historical perspective lends credibility to the conclusion that another 100 basis-point rise in the 10-year yield, even over the next nine to 12 months, could have a meaningful effect on U.S. growth. The impact could be more devastating during this cycle, when current GDP growth of 2.0–2.5% is half of the 4–5% that characterized our historical examples.

So where's the tipping point? Based on a 10-year Treasury yield of 2.75% as of November 11, 2013 (according to Bloomberg), it could be around 3.5–4.0%. Once again, the timing of such a move, and the health of the U.S. economy when it does occur, will be critical factors. Fed officials are keenly aware of this as they consider their next policy move.

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