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The perks and pitfalls of rising rates

September 18, 2013

| MoneyRates.com Senior Financial Analyst, CFA

Though the financial markets are wary of a rise in interest rates, higher rates now seem inevitable. Still, it's important to remember that higher interest rates aren't all bad. For every negative aspect of higher rates, there is also something to be said in their favor.

The end of ultra-low rates?

There are a couple of reasons higher rates now seem on the horizon. First, history suggests that current rate levels are highly unusual. On the short end of the rate spectrum, one-year Treasury securities are currently yielding about 0.13 percent, compared to a long-term average of 5.19 percent. They've now been yielding less than 1 percent for 57 straight months. In the 60 years of history available from the Federal Reserve, one-year Treasury yields had previously been at less than 1 percent for just five months back in 1954.

Further out on the yield curve, 10-year Treasury securities tell a similar story. They are currently yielding 2.74 percent, compared to a long-term average of 6.12 percent. These bonds have been yielding less than 3 percent for 25 straight months now, and also spent part of 2008, 2009 and 2010 at less than 3 percent. Prior to that, you would have to go back to 1958 to find 10-year Treasury yields at less than 3 percent.

Besides the fact that today's low rates are such historical outliers, the second reason that higher rates seem inevitable is that rates are so low today largely because of extraordinary intervention by the Federal Reserve. It's safe to assume that this intervention can't go on forever, so eventually rates will be allowed to rise to more normal levels.

While the prospect of higher rates makes the financial markets nervous, it's important to remember that rising interest rates have upsides in addition to their downsides. Here are some of the good vs. bad contrasts that surround higher rates.

Income generation vs. stunted wealth creation

Lower interest rates have contributed to asset appreciation in the stock market and real estate, adding to the wealth of millions of Americans. However, the problem is that wealth today doesn't generate much income, with savings account rates near zero and bond yields not much higher. At 5 percent savings account rates, a million dollars would generate $50,000 a year in income. At a 0.10 percent savings account rate, it would take $50 million to generate the same amount of income.

So, while higher rates might stunt wealth creation, they would make it possible to generate much more income with savings.

Growth vs. inflation

Rates are likely to rise in response to one or both of these two factors: stronger growth or higher inflation. Obviously, the good scenario here is higher rates driven by stronger growth, because this would boost corporate earnings and personal income. It's only if higher rates come from rising inflation that there would be no benefit to offset the cost of higher rates.

Cheap credit vs. easy credit

Recent years have seen some of the lowest mortgage rates in history. The rub is that it has been tough to qualify for a mortgage with anything less than perfect credit. Higher rates might be more expensive, but they would give banks more of an incentive to lend money, so credit terms might get easier.

In short, for all the concern about higher interest rates, if a return to more normal rates heralds a return to a more normal economy, there will be plenty of good to offset the bad.

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