Earlier this year, the Federal Reserve hinted that it would raise the federal funds rate this year.
On May 22, 2015, Federal Reserve Chair Janet Yellen stated, “For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target.”(Source: Federal Reserve, last accessed May 22, 2015.)
While the Fed didn’t give a specific time frame, many analysts thought it could happen as early as June. With a raft of weak economic data rolling in, most now believe it will happen in September.
Should the Federal Reserve raise interest rates later this year, it will be interesting to see how this move impacts the bond markets, fragile housing market, and overall U.S. economy.
Interest Rates Rise, Bond Market Plunges?
Over the past six years, the Federal Reserve bought trillions of dollars in mortgage and treasury bonds in an effort to maintain liquidity, encourage borrowing, and spur investment in economic activities.
When it comes to investing in the bond market, investors have to keep one simple thing in mind; as interest rates rise, bond prices decline, and yields increase.
When the interest rate rises, I’m afraid that the bond market will be setting up for a massive sell-off. In the past few months already, it seems that investors are running for the exits. For example, look at the yields on 10-year bonds. They have increased more than 30% since February.
Impact on the Housing Market
The bonds market isn’t the only victim of higher interest rates; the housing market will be hurt as well. The housing market and interest rate have a negative relationship. If interest rates rise, home prices face pressure.
In its March economic projection, the Federal Reserve said it expects the federal funds rate to be around 0.625% and 1.625% in 2015 and 2016, respectively—up from the current 0.25% level. Though these interest rates may not sound very high, from the current low level, this move will be substantial; an increase in the region of 150% to 550%. (Source: Board of Governor Members of the Federal Reserve System, last accessed, May 22, 2015.)
Consequently, mortgage rates will see similar hikes since they are tied to the federal funds rate. On top of that, higher mortgage rates will make homes significantly less affordable for Americans. And those who want to sell could have trouble doing so.
Impact on Already Fragile U.S. Economy
U.S. gross domestic product (GDP) barely grew in the first quarter of 2015, at an annual rate of 0.2%. I expect this number to be revised down again.
In a May 20 press release, the Federal Reserve blamed the severe winter weather in some regions and the labor dispute at West Coast ports as the main reasons for slowing first-quarter growth. In fact, it maintains the dismal growth is just a hiccup. (Source: Federal Reserve, May 20, 2015.)
On the other hand, higher interest rates could cause the greenback to appreciate even more against other currencies. A stronger U.S. dollar will reduce exports since American goods and services become more expensive for foreign consumers. Moreover, it could hurt the country’s struggling industrial and manufacturing output even more.
I discuss how U.S. manufacturing is slowing down in a previous article. (See “U.S. Manufacturing Slowing Down; Regional Data Suggests Trouble Ahead.”)
All told, if the current bond market transitions into a crashing bond market, potential home buyers will continue to struggle. On top of that, industrial and manufacturing output will continue to face headwinds. As a result, I will not be surprised if the U.S. enters a recession in late 2015 or 2016.