From homes to car loans, interest rates bounce through the economy

Just look at mortgage rates. In early 2022, the average interest rate on 30-year mortgages was above 3%. Today it is 4.72% according to Freddie Mac. This translates into increasingly higher borrowing costs for Americans to buy a home — and that’s only the beginning.

For the better part of the past 15 years, households and businesses paid little to borrow. Americans can get cars and homes and appliances to fill up on interest rates in the low single digits. Companies, especially profitable ones, can practically name their price in credit markets.

The Federal Reserve, facing inflation that has climbed to its highest level in 40 years, has been indicating for months that unfiltered credit is counting these days. The market has reacted tremendously in the last few weeks.

As recently as December, investors were betting that prices would moderate on their own and the Fed would raise its benchmark federal-funds rate by about 0.75 percent this year, made up of three quarter-point moves. Now, investors are pricing in a rate that tops out at 2.5% by the end of this year and 3% next, the highest rate since the 2008 financial crisis.

It has raised yields on government bonds in recent weeks. The Treasury yield largely reflects investor expectations for short-term interest rates set by the Fed. When the Fed raises rates or signals, investors sell government bonds, raising their yields. Now this is happening in a dramatic fashion.

Rising Treasury yields, in turn, are cascading throughout the economy as higher borrowing costs, squeezing homes and businesses alike. As rates rise, car loans, credit cards and corporate loans all become more expensive.

Consider Home Depot Inc., which last month sold $1.25 billion worth of slug bonds maturing in 10 years with a 3.25% interest rate. The retailer, which rode the home-renovation boom of the pandemic to big profits, sold 10-year bonds at a mere 1.875% rate about six months ago.

The Fed’s previous efforts to raise interest rates since the financial crisis have faltered. In 2013, then-chairman Ben Bernanke said that the Fed would eventually begin to slow the bond purchases it was doing to keep rates low. This was enough to prompt a panic sell-off 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 next year.

“Slow economic growth is a risk, but the Fed has to take that risk,” said Greg McBride, chief financial analyst at Bankrate.com. “Inflation is at 40-year high; it’s time to take off the gloves and get busy.”

No one is feeling the effects of higher borrowing costs like the American home buyer.

When Jennifer Osorio started planning to buy a home in Houston earlier this year, she thought she’d end up with a mortgage rate closer to 3.5%. By the time she was ready to make an offer last month, the lowest rate she’d found was 4.99%.

The higher rate would add a few hundred dollars to her monthly payment, which she expects to keep around $1,200. Before rates went up, she was looking at homes priced up to $230,000. Now, he’s looking for listings closer to $180,000. He skips most condos, which are smaller than the house she was hoping for, or the house where she teaches, long commutes.

“It’s disappointing, but there’s not much I can do,” said Ms Osorio. “I expect the market to crash.”

To a large extent, this is all by design. The Fed is raising rates to curb borrowing and thereby slowing 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 each other to borrow for a night.

The Fed also holds bonds and mortgage-backed securities, and the speed at which it buys or sells can also affect rates in the broader economy.

When the Fed is trying to cool a warming economy, it raises the fed-funds rate, lowers its bondholding and signals that it will do the same in the future. Those moves have a particularly obvious effect on mortgage rates.

The 30-year mortgage rate on offer is limited to the yield on the 10-year Treasury, increasing in anticipation of future rate increases. What’s more, the Fed’s decision to reduce its holdings of mortgage bonds means that issuers must offer higher yields to attract investors — a cost that lenders pass on to borrowers in the form of higher interest rates.

Economists expect higher rates to push some potential home buyers out of the market and reduce demand. There are signs that this is 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. Again, the average 30-year rate stood at about 3.18%. Refinance applications declined 62% in the same 12-month period.

Higher rates will make monthly mortgage payments—already at least affordable since November 2008—even less. According to the Federal Reserve Bank of Atlanta, an average American household needs 34.2% of their gross income to cover the mortgage payment on an average-priced home in January. This is up from 29 per cent a year ago.

Back then, this was largely a function of double-digit increases in home prices. Now, the burden of higher rates is also falling on affordability.

“Wages and wages are not keeping pace with the double whammy of higher prices and rising mortgage rates,” said George Ratio, senior economist and manager of economic research at Realtor.com. Operates Realtor, the parent of the Wall Street Journal. .com.

The Fed plays a decisive role in setting interest rates in the economy, but not all debt responds to its actions in the same way.

Interest rates on some loans, such as credit-card balances and the kind of loans private-equity firms use to buy companies, rise in tandem with the fed-funds rate. Rates on those loans haven’t gone up much yet. The Fed has raised its benchmark rate by only a quarter point this year to between 0.25% and 0.5%.

Many mortgages, auto loans and corporate bonds are more influenced by what investors think short-term rates will be in the future than they do. Those rates are rising rapidly, although they only apply to new loans and bonds, rather than existing ones.

According to Bankrate.com, the average rate on a new car loan with a five-year term jumped to 4.21% in early April, up from 3.86% at the beginning of the year.

The average yield on investment-grade corporate bonds, a measure of the cost of new borrowing for businesses with strong balance sheets, is now around 3.8%, up from 2.3% at the beginning of the year.

The yield on low-rated corporate bonds has increased from 4.2 per cent to 6.3 per cent. These rates have led to a sharp decline in lending among already under-rated companies.

According to Leveraged Commentary & Data, a research and news provider, businesses issued $157 billion of sub-investment-grade bonds and loans through March this year, up 53% from a year earlier and since the end of 2019. Lowest quarter total. The recession followed an increase in issuance in late 2020 and through 2021, driven largely by businesses paying off old high-cost debt with new low-cost bonds and loans.

For now, interest on low-rated corporate loans is fairly low by historical standards. Investors seeking to hold bonds on Treasuries based on the relatively modest additional yield are not concerned that businesses are being threatened by a lack of access to funding.

That could change, Bank of America strategists said in a recent note, if bond issuance doesn’t pick up pace by mid-May, leaving investors more concerned that the price of businesses is pulling out of the market. and is deprived of cash.

People and businesses seeking new loans feel the effects of rising rates most eagerly. But borrowers who have already closed their loans are also unsecured if their rates are floating, meaning they rise and fall along with short-term rates or Treasury yields.

Credit cards are linked to the prime rate, which closely tracks the fed-funds rate. The annual percentage rate borrowers typically pay on their card balances includes the prime rate plus the margins made by lenders. According to Bankrate.com, the average credit-card APR was 16.4% on April 6. It was 16.3% on 5 January.

That doesn’t mean people with credit-card debt won’t feel the sting of higher rates.

Brian Riley, director of credit advisory services at payments research and advisory firm Mercator Advisory Group, said rates and consumer prices are likely to rise, at least for a while. In turn, consumers may start putting more on their credit cards to make up for the gap between what they’re bringing in and what they’re paying, mitigating the impact of rising rates.

This could prompt lenders to tighten credit, Mr Riley said. “Lenders have to be a lot more conservative,” he said. “They’re not going to lend blindly in a storm.”