The recent uptick in long-term interest rates may signal that the end of a long period of cheap credit is at hand. That means the economy is humming, but what would higher interest rates mean for consumers?
Government statistics show that consumer spending levels have been higher than income levels for years, prompting economic worrywarts to conclude that an eventual slowdown in consumer spending levels is inevitable. If interest rates make a sustained move to the upside now, that thesis will be put to the test.
"The employment market is healthy, but consumer liquidity, which has been supporting consumer spending growth above the level of income growth, is drying up," says Colin McGranahan, a retail analyst with Sanford C. Bernstein. "A steepening yield curve only accelerates that. It makes me think that this might push down on the consumer spending deceleration button in the coming months."
The yield on the 10-year Treasury note was recently hovering near 4.9%, a level it hasn't reached in almost a year. Some investors say it's headed for 5%, which would mark its highest level since 2002.
For most of last year the yield on the 10-year stayed at 4% to 4.5%, even while the
moved short-term rates into that range. Normally, such a move by the Fed would goose longer-term rates higher, because bond buyers typically demand a higher rate of return for a longer time horizon on their investments. When this didn't happen, now-retired Fed Chairman Alan Greenspan famously called the situation a "conundrum."
The plot thickened late last year when short-term rates climbed higher than long-term rates, creating an inverted yield curve. Inverted yield curves have, in the past, signaled the onset of an economic recession. This time around, Greenspan voiced the widely held opinion that foreign demand for long-term U.S. bonds was pushing down long-term rates, so the inverted yield curve wasn't a sign of an economic slowdown.
So far, the Greenspan crowd has been right. Now long-term rates are moving up again, prompting some observers to conclude that, rather than heading for a slowdown, the economy is heating up and the increase in long-term rates is only the beginning.
"The low-interest rate cycle that really began in 1982 but has gone to extremes in the last four years may be coming to an end here," says Paul Mendelsohn, chief investment officer with Windham Financial Services. "Gold is telling us that. Commodity prices are telling us that. It looks like the dollar may be getting ready to tell us that. You have a developing set of circumstances that could send interest rates up quite a bit."
If the economy is strengthening and capital is getting ready to start flowing out of the bond and commodity markets, stock market investors hope they will benefit. That might explain why the
perked up roughly 2.2% over the last two weeks while the 10-year jumped 25 basis points. Meanwhile, some sectors, including retail, moved to the downside as uncertainty about higher rates moved some investors to seek cover.
Since March 21, the S&P Retail Index has slipped 2%, with major stocks like
shedding 3.3% and 4.1%, respectively.
McGranahan points to government data on wage growth and consumption, which suggest that consumers are continuing to spend more than they earn at historically high levels. In January, the most recent month for which data is available, wages grew by $284 billion on an annualized basis. Spending jumped by $580 billion, suggesting that $296 billion came from sources like savings, capital gains, borrowings and home-equity extractions.
Over the past 20 years, consumption has outpaced wage growth in the U.S. economy by 0.5 percentage points, on average. From early 2001 to late 2004 the margin grew to 2.5 percentage points. Last year, the margin normalized, but data from recent months show the gap is widening again.
Much of the extra spending in recent years came from home-equity loans, as homeowners found themselves in the midst of a dramatic boom in real estate prices. That source of funds is now drying up as rates rise and the housing market cools. In September, the balance of home-equity loans at commercial banks rose 40% from a year earlier. By February, such loans had just 5% year-over-year growth.
"Home-equity loans have floating rates, so they're moving up now," says McGranahan. "They're costing people more money now and those debt-servicing costs will continue to climb with interest rates."
Debt-service payments rose 9% year over year in the fourth quarter of 2005, the highest rate of growth since 2001. Growth in consumer credit has slowed to a crawl in recent months.
"We're not talking about a scenario here when the consumer rolls over and dies, but certainly, the steepening yield curve and the liquidity situation suggest that some slowdown in spending is probably in the cards," says McGranahan.