The Next Crisis Has Just Begun

Many investors focus their full attention on stocks. However, the crazy things that are going on in the credit markets pose the biggest threat -- both to the economy and your financial future.

Yes, the 40% rise in the stock market since early March qualifies as impressive. It pales, however, in comparison to some of the behavior we've seen in the fixed-income markets. Here's a brief rundown:

  • After hitting record lows back in December, yields on 10-year Treasuries have almost doubled, briefly topping 4% on Wednesday -- and hitting their highest levels since October. Yields on 30-year bonds, meanwhile, hit a 20-month high.
  • Mortgage rates have followed suit, with a jump of about three-quarters of a percentage point on 30-year fixed mortgages in just the past two weeks.
  • Oddly enough, though, high-yield bonds have seen rates come down recently.
  • Similarly, savers are getting less in interest, as yields on bank CDs and short-term accounts come down.

The combination of higher borrowing costs and lower returns on savings could create lasting problems for consumers and the economy as a whole.

Rising rates
For months, the U.S. government and the Federal Reserve have cooperated for their mutual benefit. With its program of quantitative easing, the Fed pushed long-term rates down temporarily, allowing homeowners and businesses alike to refinance debt at more attractive rates. Lower rates also helped the government raise money to finance its huge expenditures.

Now, though, higher rates will raise the government's cost of borrowing. Currently, almost $4 trillion of the public debt is financed by notes and bonds with maturities from two to 30 years. Moreover, rates on $2 trillion in short-term bills are already near zero -- and could start rising early in 2010, if the economy starts to move forward. Although the Treasury has locked in relatively low rates on its existing debt, each percentage point in higher borrowing costs when it eventually has to refinance that debt will equate to roughly $70 billion in additional interest expense. With the government already running big deficits, that number will only increase over time.

The move in Treasuries has forced mortgage lenders to raise rates as well. With 30-year Treasury rates starting to approach 5%, it obviously didn't make sense for capital-hungry banks like Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and Wells Fargo (NYSE: WFC  ) to offer mortgage rates that recently reached well below the 5% level. Now, average 30-year mortgages are close to 5.75%. That bodes ill both for those hoping to refinance existing mortgages, and for those thinking about buying new homes.

Falling spreads?
You'd think that if high-quality debt were suffering, high-yield junk bonds would be even harder hit. But the opposite is the case. Junk bonds have rallied strongly since the March lows, with bonds of retailers such as Sears Holdings (Nasdaq: SHLD  ) and Saks (NYSE: SKS  ) sporting returns greater than 35%.

While that's good for bondholders, it's mixed news for the debt-laden companies that issue the bonds. Some companies, such as Harrah's Entertainment, took advantage of March's lows to make attractive deals to refinance existing cheap debt. Now that rates have fallen and prices are higher, companies that didn't act quickly, such as MGM Mirage (NYSE: MGM  ) , face a much more challenging environment.

Moreover, savers trying to invest in fixed-income vehicles face lower yields as well. Even those willing to commit to a five-year CD at institutions like Discover Financial (NYSE: DFS  ) can get only about 3.5%, and rates on shorter-term accounts are often much lower.

What to do
These rate trends will squeeze everyone from the government and big institutions to average consumers. Higher Treasury rates will eventually force the government to rein in its spending, which will remove what has been an important crutch supporting economic activity. That could send the economy into a new crisis.

Meanwhile, on a personal level, with rates on savings lagging behind borrowing costs, it's extremely important to lock in reasonable fixed rates on debt now, while trying to cut back on high-rate borrowing. Investors who took on the default risk of junk bonds have reaped great rewards, but you're now getting a smaller reward for it -- and if the economy stays weak, that risk could increase dramatically.

Stock investors need to stay aware of how other markets affect them. Even with the stock market rallying, the strange action in the credit markets spells just the beginning of a new threat to the economy's health.

More on investing in hard times:

Learn how Fool co-founders David and Tom Gardner are handling market turbulence in their Motley Fool Stock Advisor newsletter. Each month, they share their insight with new stock recommendations and much more. Try it out free for 30 days and see for yourself how much you can learn.

Fool contributor Dan Caplinger is as ready as he'll ever be for the next crisis. He doesn't own shares of the companies mentioned. Discover Financial and Sears Holdings are Motley Fool Inside Value picks. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy never creates a crisis.


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