June 22, 2007 / 5:52 PM / 12 years ago

Bond yields encroach on economy's pain threshold

NEW YORK (Reuters) - A sustained push above 5 percent on the yield of the benchmark 10-year Treasury note could roil markets, deepen housing woes and slow the U.S. economy.

At first glance, a 5 percent handle should not trouble consumers. It’s still a far cry from the 10-year Treasury note’s all time yield peak of 15.84 percent in September 1981, according to Global Financial Data. Then, inflation was rampant, the Federal Reserve was hiking interest rates and the U.S. economy succumbed to recession.

However, current U.S. consumer and corporate borrowing at low interest rates after a historic rate cutting cycle leaves debtors vulnerable to even a modest rise of bond yields. A rise to 5.5 percent of the 10-year yield would test the economy’s current pain threshold, strategists say.

“The housing market has been totally dependent on cheap money,” said Mary Ann Hurley, senior Treasuries trader in Seattle at brokerage D.A Davidson.

The Fed axed interest rates to a four-decade low of 1 percent in June 2003, helping to accelerate an unprecedented boom in house prices, which peaked around 2005. Now, homeowners who took out adjustable-rate mortgages at lower rates are at the mercy of rising yields, while all homeowners could lose out if home prices continue to fall.

“A 10-year yield above 5 percent is really going to impact housing and will hurt people who have to refinance from their ARMs because rates are dramatically higher,” Hurley said.

A rise of the 10-year to 5.5 percent would push up the 30-year fixed rate mortgage to about 7.15 percent.

“That would price a lot of folks out” and “would slow the recovery of the housing market,” says Douglas Duncan, the Mortgage Bankers Association’s chief economist.

A 7.15 percent, 30-year fixed mortgage rate, if sustained for a year, would cut combined U.S. new and existing home sales by 310,000 units to 6.53 million, says Mark Zandi, chief economist with Moody’s Economy.com in West Chester, Pennsylvania. Instead of existing home prices falling nearly 5 percent over the next year — Zandi’s current forecast — they would then fall 6 percent, he predicts.

“We are already at that point where higher interest rates are going to start inflicting damage. Anything above the 5.5 percent level will inflict real pain,” Hurley said.

For the moment, the bond market selloff has paused as bargain hunters were drawn in by yields above 5 percent. The recent recovery has pulled the 10-year yield down from five-year highs above 5.30 percent last week, to 5.15 percent

on Friday. Bond yields and prices move inversely.

The 10-year Treasury note yield is the key determinant of 30-year fixed rate mortgages, which are widely used by U.S. homeowners.

Last week’s spike in Treasury yields sent average interest rates on 30-year mortgages jumping briefly to 6.74 percent according to a weekly survey by finance company Freddie Mac FRE.N.

The 10-year Treasury yield is still within sight of the pivotal 5.25 percent level. A decisive move above that could catapult bonds into a long-term bear market, fixed income strategists argue, crimping financing for private equity firms, consumers’ ability to obtain more credit and corporate debt issuance.

Smaller businesses are mostly dependent on credit card rates, driven by the prime lending rate, which has been steady at 8.25 percent for about a year, so are insulated from bond yields shifts for now, says Greg McBride, senior financial analyst with personal finance web site Bankrate.com.

Bond investors’ persistent worries about global economic growth, inflation and the threat of central bank interest rate hikes could make yields resume their upward march, according to some bond analysts.

And to return to long term norms, the 10-year yield should rise to about 5.75 percent to roughly match the nominal rate of gross domestic product growth, (the real GDP rate plus headline inflation), said Jack Ablin, chief investment officer with Harris Private Bank in Chicago.

“Given that we have been accustomed to these lower interest rates, certainly any change like that will have a negative reaction,” Ablin said.

A 5.75 percent, 10-year yield would likely push the 30-year bond yield up to 6 percent and mortgage rates to about 7.25 percent, Ablin expects. Between three and six months at those levels would wreak damage on the housing sector, he added.

“We are only about half way through the pain in housing anyway and that will just prolong the pain,” Ablin added.

The housing market is more vulnerable to even modest rises in borrowing costs this time around, some believe.

“In most housing downturns it is rising yields that cause the downturn. This downturn was caused by prices rising very rapidly relative to incomes,” said Paul Kasriel, director of economic research with The Northern Trust Company in Chicago.

“If interest rates are rising that would be a double negative for the housing market,” Kasriel said.

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