Just look at mortgage rates. At the start of 2022, the average interest rate on a 30-year mortgage was hovering above 3%. Today, it stands at 4.72%, according to Freddie Mac. That translates to significantly higher borrowing costs for Americans looking to buy a home — and that’s just the beginning.
For most of the past 15 years, households and businesses have paid very little to borrow. Americans could get cars, homes and appliances to fill them up at sub-10-figure interest rates. Companies, especially profitable ones, could practically name their price in the credit markets.
The Federal Reserve, faced with inflation that has reached its highest level in 40 years, has been signaling for months that those days of unfettered credit are numbered. Over the past few weeks, the market has reacted strongly.
As recently as December, investors were betting that prices would largely moderate on their own and that the Fed would raise its benchmark federal funds rate by about 0.75 percentage points this year, made up of movements of three quarter points. Investors now expect the rate to peak at 2.5% by the end of this year and 3% next, its highest level since before the 2008 financial crisis.
This has sent government bond yields skyrocketing in recent weeks. Treasury yields largely reflect investors’ expectations of short-term interest rates set by the Fed. When the Fed raises rates or signals that it is about to do so, investors tend to sell government bonds, which pushes their yield higher. This is happening now, dramatically.
Rising Treasury yields, in turn, ripple through the broader economy in the form of higher borrowing costs, which squeezes households and businesses. Auto loans, credit cards and business debt are all likely to become more expensive as rates rise.
Consider Home Depot Inc., which last month sold $1.25 billion in bonds maturing in 10 years with an interest rate of 3.25%. The retailer, which took advantage of the pandemic home improvement boom to make big profits, sold 10-year bonds at a rate of just 1.875% about six months earlier.
Previous attempts by the Fed to raise interest rates since the financial crisis have failed. In 2013, then-Chairman Ben Bernanke said the Fed would eventually start to slow the bond purchases it was making to keep rates low. That was enough to cause panic selling in the bond markets. In 2018, the Fed raised interest rates four times. The stock market fell 6% and the Fed turned around and began cutting rates the following year.
“Slower economic growth is a risk, but it’s a risk the Fed needs to take,” said Greg McBride, chief financial analyst at Bankrate.com. to be busy.”
No one feels the effects of rising borrowing costs quite like the American home buyer.
When Jennifer Osorio started considering buying a house in Houston earlier this year, she thought she would end up with a mortgage rate close to 3.5%. When she was ready to make an offer last month, the lowest rate she could get was 4.99%.
The higher rate would add a few hundred dollars to her monthly payment, which she hopes to keep around $1,200. Before rates took off, she was looking at homes that could be priced as high as $230,000. Now she is looking for listings closer to $180,000. That mostly leaves condos, which are smaller than the house she was hoping for, or houses with longer trips to the school where she teaches.
“It’s frustrating, but there’s not much I can do,” Ms Osorio said. “I’m just going to have to hope the market crashes.”
To a large extent, this is all intentional. The Fed raises rates to limit borrowing and thus slow the economy to fight inflation.
The Fed’s main tool against inflation is interest rates. The central bank creates a floor for borrowing costs in the economy by setting a target for the federal funds rate, which is what banks pay themselves to borrow for a single night.
The Fed also holds bonds and mortgage-backed securities, and the speed at which it buys or sells them can also affect rates across the economy.
When the Fed tries to calm an overheated economy, like today, it raises the fed funds rate, reduces its bond holdings and signals that it will do the same in the future. These movements have a particularly pronounced effect on mortgage rates.
The proposed 30-year mortgage rate is tied to the 10-year Treasury yield, which rises in anticipation of future rate hikes. Additionally, the Fed’s decision to reduce its holdings of mortgage bonds means issuers must offer higher yields to entice investors — costs that lenders pass on to borrowers in the form of higher interest rates.
Economists expect higher rates to drive some potential buyers away from the market and reduce demand. There are signs starting to happen. Mortgage applications in the last week of March fell 9% from the same period a year ago, according to the Mortgage Bankers Association. Then, the 30-year average rate hovered around 3.18%. Refinance applications fell 62% over the same 12-month period.
Higher rates will make monthly mortgage payments – already at the least affordable level since November 2008 – even less. A median U.S. household needed 34.2% of its gross income to cover mortgage payments on a median-priced home in January, according to the Federal Reserve Bank of Atlanta. That’s up from 29% a year earlier.
Then it was largely a function of double-digit house price increases. Today, higher rates are also weighing on affordability.
“Wages and salaries just aren’t keeping up with the double whammy of rising prices and rising mortgage rates,” said George Ratiu, senior economist and head of economic research at Realtor.com. News Corp, parent company of The Wall Street Journal, operates Realtor.com.
The Fed plays a decisive role in setting interest rates across the economy, but not all lending responds to its actions in the same way.
Interest rates on certain debts, such as credit card balances and the type of loans that private equity firms use to buy businesses, are rising in line with the federal funds rate. The rates for these loans have not yet increased significantly. The Fed has only raised its key rate this year by a quarter point, to a range between 0.25% and 0.5%.
Many mortgages, car loans and corporate bonds are influenced more by what investors think short-term rates will be in the future than by what they are now. These rates increase faster, although they only apply to new loans and bonds rather than existing ones.
The average rate for a new car loan with a five-year term hit 4.21% in early April, according to Bankrate.com, from 3.86% at the start of the year.
The average yield on investment-grade corporate bonds, a measure of the cost of new borrowing for companies with strong balance sheets, is now around 3.8%, down from 2.3% at the start of the year.
Yields on lower-rated corporate bonds rose from 4.2% to 6.3%. These rates have already led to a sharp slowdown in borrowing by lower-rated companies.
Companies issued $157 billion in below-investment grade bonds and loans this year through March, down 53% from a year earlier and the lowest quarterly total since the end of 2019, according to Leveraged Commentary & Data, a research and news provider. The slowdown followed an increase in issuance at the end of 2020 and into 2021, mainly due to companies paying off older, higher-cost debt with new bonds and new low-cost loans.
For now, interest on lower-rated corporate debt remains fairly low by historical standards. Based on the relatively modest additional yield investors are demanding to hold the bonds relative to Treasuries, they don’t seem worried that companies are threatened by a lack of access to finance.
That could change, Bank of America strategists said in a recent note, if the pace of bond issuance doesn’t pick up by mid-May, making investors more worried that companies will be shut out. market and deprived of liquidity.
Individuals and businesses wishing to take out new loans are feeling the effects of rising rates the hardest. But borrowers who have already locked in their loans are also vulnerable if their rates are floating, meaning they rise and fall with short-term rates or Treasury yields.
Credit cards are pegged to the prime rate, which closely tracks the federal funds rate. The annual percentage rate that borrowers typically pay on their card balance consists of the prime rate plus a margin added by lenders. The average credit card APR stood at 16.4% on April 6, according to Bankrate.com. It was 16.3% on January 5.
That doesn’t mean people with credit card debt won’t feel the sting of higher rates.
Consumer rates and prices are expected to rise in tandem, at least for a while, said Brian Riley, director of credit advisory services at Mercator Advisory Group, a payments research and advisory firm. Consumers, in turn, could start putting more on their credit cards to cover a shortfall between what they bring in and what they pay, compounding the effect of rising rates.
That could prompt lenders to tighten credit, Mr Riley said. “Lenders need to be much more conservative,” he said. “They’re not going to lend blindly in a storm.”