Down Arrow Button Icon

The view that the historic surge in housing prices has legs, that stocks will keep booming despite steep valuations, and that America can afford trillions in new borrowings all share, or used to share, the same assumption: that interest rates will remain super-low for at least a few more years. Now, the sudden, shocking jump in the yield on the benchmark 10-year Treasury note (long bond) has brought the scenario that’s underpinning so many favorable trends into serious doubt. Rising rates are already cooling the hot run in home prices, shrinking the edge equities held over bonds that the bulls love to spotlight, and upending the conviction that the U.S. can amass gigantic new debt while its interest outlays fall.

An unexpected spike in yields

As recently as November 2018, the long bond was yielding 3.22%. Then fears that a trade war with China would trigger a recession moved the Fed to push the short-term rates it controls to ultralow levels, a campaign that continues to this day. It now appears that the market is defying the Fed by taking control of the “long end.”

After starting 2020 at 1.88%, the 10-year cratered with the economy. From mid-April to mid-October, its yield hovered between 0.5% and 0.75%, and entered 2020 at 0.93%. The big ramp started on Feb. 1. In just seven weeks to March 18, the long bond yield has leapt from just over 1.0% to 1.73%, its highest reading since January of last year. The 30-year yield has followed, rising from 1.66% at the beginning of 2021, to 2.5%.

A combination of higher than anticipated inflation and rising “real” (inflation-adjusted) rates are boosting the long end of curve. The jump in real rates is especially troubling. Over long periods, inflation-adjusted yields tend to track growth in GDP. Now, their quick rise may be reflecting both a resurgent economy, and pressure from the giant borrowing binge that began last spring. The $5 trillion in debt the U.S. has added since the start of 2020, plus the flood of borrowing to come from the $1.9 trillion American Rescue Plan, the proposed infrastructure initiative, and big structural deficits, could well be a major force in swelling the real rate that’s so important to housing, stocks, and the federal budget.

A return in inflation-adjusted yields even to historic levels would endanger all three. Ultra-favorable real rates are supposed to justify how housing and stocks can keep soaring, and federal interest outlays remain manageable despite the explosion in spending. Getting back to normal would pull home and equity prices back to normal as well––meaning they’d drop—and radically alter the debt outlook from “we’ll deal with it later” to the “deluge is at hand.”

Costlier mortgages

Nothing is more important to housing prices than the monthly payment on the 30-year home loan. From October 2018 to December 2020, the rate on that American classic dropped from 4.86% to 2.67%. That historic drop triggered the boom that continues to this day, but may soon be in danger.

But the 30-year rate follows the trend in the long bond. The recent jump in 10-year yields lifted mortgage rates to 3.45% as of March 18, back to the levels of last March. That rise makes a big difference in the budgets of middle Americans. Since the start of the year, the fixed monthly payment has risen from $820 to $884. The extra $60-plus doesn’t sound like much, and it’s not making a huge difference yet. But the increase has already slowed the historic acceleration in prices. Given that the drop in rates inflated prices, making similar homes a lot more expensive, a return to a more “normal” rate on the 30-year could turn the strongest rise on record into a slide.

Ed Pinto, director of the American Enterprise Institute Housing Center, predicts that prices will rise around 13% in both March and April, based on contracts signed a month or two before. That’s double the pace in January 2020, and from last summer through the closings come in April, prices have been marching to higher and higher peaks. Driving the gains: the confluence of tight supply––inventories dropped almost 50% in the past year––and those bargain rates that lure buyers by restraining monthly payments even as prices sprint.

But by May, Pinto reckons that year-over-year gains will throttle back to around 11%. “The purchase market should be strong up to a 4% rate on 30-year home loans,” he says. “It wouldn’t keep advancing at 11%, but it could run at 8%. That’s still way higher than what’s sustainable. At 4.75%, prices might be rising at 2%. But it would take a 5% rate to put the brakes on. Then you’d see prices decline.”

The reason prices are unusually vulnerable to rising rates is precisely because houses have gotten so much pricier. Paying 35% more than what the same ranch was selling for two years ago, and also paying a couple of extra points on your home loan, would raise monthly costs to the point where only a steep drop in prices would restore affordability. Pinto offers an example. A couple who purchased a $250,000 home with a $50,000 down payment and a $200,000 mortgage at 3.0% a couple of years ago is paying around $820 a month. A similar house across the street could cost $340,000 today. And if rates indeed get to 5%, about where they stood in November 2018, they’d be paying $1,557, or almost double.

We’re now within 1.5 points of the number that’s the tipping point, about a point closer than late last year. Though 5% may seem a long way off, the convergence of higher inflation that is already expected, a borrowing blowout with years to run, and a strong economy could easily push mortgage rates to that threshold, and send prices tumbling.

Stocks could plummet too

How bad is the doubling of yields since the start of 2021 for stocks? As for housing, it’s not so much what’s happened yet, but what may lie ahead. Treasury rates have two components: the inflation portion that keeps investors even with prices, and the “real” number that provides a return over and above, say, the CPI. It isn’t such a problem when rates rise because investors are expecting an increase in future inflation. Companies’ sales and profits rise with overall prices; it’s those producers that are pushing the prices of SUVs and smartphones higher. The threat for stocks is a big rise in “real rates” that may well be underway.

The reason: The lower real rates go, the better stocks look versus their main rivals, fixed-income securities, including the benchmark 10-year Treasury. At the start of the year, the long bond was yielding 0.93%. Since expected inflation over the next decade stood at around 2%, it offered a negative, inflation adjusted return of minus 1.07%. That dreadful number made stocks look good by comparison. The Wall Street manifesto held that even though equities appeared pricey, they were a bargain compared with exorbitantly expensive bonds.

The metrics that illustrated equities’ edge over bonds, and that the optimists loved to cite, is the difference between the S&P 500 earnings yield and real yield on the 10-year Treasury. I’ll put normalized EPS for the S&P at $140; that’s its record level in Q4 of 2019. Using that number, the S&P’s earnings yield at the start of this year was 3.7% (that’s its price of 3756 divided by profits of $140 a share).

In most times, that would be an unattractive number. But compared with bonds it looked pretty good. On January 4, the S&P earnings yield beat the minus number on Treasuries by a big 4.77%. Stocks kept doing great, not because they were cheap––not by a long shot––but because they offered such a fat premium over ultra-expensive bonds.

As of the close on March 18, the S&P had gained 11% to 3974, shrinking the earnings yield to 3.5%. At the same time, the “real yield” on the long bond had risen from a negative 1.07% to minus 0.5%, based on projected average inflation of 2.3% over the next decade. The equities’ advantage went from 4.77% to 4%. That doesn’t sound catastrophic, but if the trend continues, the upshot would be disastrous. It’s indeed possible that the real yield has climbed all the way into slightly positive territory, since the current as opposed to projected rate of inflation is now around 1.6%. The estimated rate over the next 10 years, at 2.3%, is a highly uncertain number.

Higher real rates will inflict their biggest damage on pricey tech stocks. Real yields are a key part of the discount rate applied to future earnings. Titans such as Amazon, Tesla, and Netflix that account for a huge share of the S&P’s value are selling at big multiples, meaning investors expect the lion’s share of their profits to roll in five, 10, and 15 years from now. By contrast, value stocks such as energy and banking have a much bigger slice of total future profits arriving in the next few years.

A rise in real rates hits expensive tech much harder because much more of their profits must be discounted back, at the new, higher rates, making their “present value” a lot lower. A revaluation of those super-rich names may already be underway. Since its mid-February peak, the Nasdaq has shed 7% of its value, including a drop of 3% on March 18.

The overall economic picture

In early February, the Congressional Budget Office released its 10-Year Budget Projections report. It contains an astounding forecast: Although its “baseline” shows U.S. debt held by the public rising from $16.8 trillion in fiscal 2019 to $26.6 trillion in 2025, an increase of almost 60%, interest expense is expected to wax by just 8% to $361 billion. The CBO posits that the category will decline sharply from 2000 to 2025, despite borrowing on a scale not seen since World War II.

The reason for the crisscross between burgeoning debt and falling interest expense is basic. The CBO was forecasting a future of ultralow rates, and especially, deeply negative real yields. In another report, also from February, the agency forecast that the 10-year rate would average 1.1% in 2021, and 1.3% in 2022, and stay there through 2024. Six weeks later, those projections are already way out of date. The long bond is now paying around 0.65% more than the CBO’s estimate for this year, and hovers well above the 1.3% forecast for 2022 to 2024.

Since the start of 2020, the Treasury has financed over 60% of the $5.2 trillion in new borrowing at maturities of under a year to restrain interest costs. Its strategy involves refinancing as much of that short-term debt as possible at longer terms. The Treasury is already getting a much worse deal on the 10-year, by paying 80 basis points more than when the year started. As of February, the U.S. had $4.9 trillion maturing in under 12 months that it must now roll over at at least a much higher cost. And the U.S. will need to borrow another approximately $4 trillion this year. Unless the Treasury reverts to issuing short-term Treasury bills, interest costs will be much higher than the CBO’s rosy projection.

The administration and economists championing new spending were reckless in predicting that real rates would remain negative for years to come. In fact, they have no idea where rates are going. In January 2020, the CBO figured that the 10-year yield would average 2.2% in 2021 and 2.6% in 2022, double the numbers from it was forecasting in February.

The simpler, more reasonable projection: The real rate pulls much closer to GDP growth, so that the 10-year returns to a far higher, and more normal, number. The administration and experts advocating huge stimulus spending bet that the world had changed. It did for a while. But the recent spike could signal that the fundamentals are once again taking charge. And that’s bad news for housing, stocks, and America’s fiscal future.