Jim Paulsen from Wells Capital Management recently said he thinks the 10-year Treasury yield will climb to more than 3.5% this year. This is a pretty bold prediction, being that the current 10-year yield is just under 2.5% and there are only seven months left in 2014.
While rates like this would certainly make bonds a more attractive investment, other areas of the economy could be adversely affected by this. Here's what a 3.5% 10-year yield could mean for housing, banking, and the overall economy, and why all investors should keep a close eye on rates.
Judging from the chart below, the 10-year Treasury rate is roughly about 1.7% below the average 30-year mortgage rate. So, if the 10-year yield rose to 3.5%, if should produce a 30-year mortgage rate of about 5.2%.
This could have a profound effect on the real estate market.
Although mortgage rates are already considerably higher than the record low 3.5% 30-year rates we saw in 2012 and the first part of 2013, they are still pretty low on a historical basis. As a result, the housing recovery has been progressing nicely, with the average home price up about 25% from the 2012 lows, according to the Case-Shiller Home Price Index.
A spike in mortgage rates could halt the gains in home prices, or even cause declines.
As you can see, rising rates and home sales generally move inversely to one another, and the more drastic the rate increase, the quicker home sales will decline.So, if rates rise considerably, we'll most likely see home prices drop, or at the very least stabilize, in order to keep buyers attracted.
The same could be said for other types of lending, such as auto loans, home equity loans, and credit cards.
Currently, the average interest rate on a 48-month auto loan is just 2.85%, and 5.7% on a $50,000 home equity loan, according to bankrate.com. If the 10-year yield rose to 3.5%, we could see auto and home equity loan rates of almost 4% and 7%, respectively, assuming the rates increase by the same amount.
Credit card interest rates vary widely, but most cards have a variable interest rate. So, in a rising rate environment, a 17.9% rate could turn into 21.9% quite easily. This would translate to an additional $40 in interest each year for every $1,000 in credit card debt.
The ripple effect of lending
Not only would a spike in rates mean the banks would take in less fee and interest income, but many other businesses would be affected as well.
For example, a $50,000 15-year home equity loan at the current rate of 5.7% comes with a monthly payment of $414. At a rate of 7%, the payment rises to $449. Less people would refinance their home to be able to afford repairs. Automakers would find it harder to sell cars at higher rates. There are many industries that would be affected as a result.
If rates rise like Paulsen projects, consumers in general will be more reluctant to spend money they have to borrow. That means less credit card spending, which would adversely affect retailers, airlines, restaurants, and other service-based businesses.
How this could affect stocks
Higher rates may be what the market is waiting for, before the big "correction" we keep hearing about finally happens.
Higher interest rates are the most surefire way to slow down an economy, mainly because they affect nearly every sector of the market in a negative way. If the rise is steady and controlled, it doesn't produce too much volatility. However, a 10-year rise to 3.5% by the end of the year would be a "spike", and we could see a pretty large correction.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.