Uh-oh. The headlines are bewailing the fact that interest rates are rising in the bond markets. This could be trouble.
Of the many factors that influence stock prices, bond interest rates have the most influence.
Rising rates make it more expensive to borrow, and companies paying more money in interest have less profit dropping to the bottom line. Homeowners with adjustable rate mortgages have less money to spend on "stuff."
This past week, the 10-year bond has seen interest rates rise suddenly and unexpectedly. This is partly because foreign governments are suddenly less interested in loaning money to us, so "the invisible hand of market forces" has had to raise the interest rate to increase the demand for U.S. government debt.
The 10-year bond is critical because home mortgage interest rates are tied to this benchmark. Interest rates on new fixed mortgages and existing adjustable rate mortgages will be rising to reflect this economic condition.
What does it all mean?
To begin with, foreigners own more than 50 percent of all U.S. government debt, and at this point, they are tired of seeing their dollar-denominated loans drop in value against other currencies.
Also, foreign governments issuing debt are paying higher interest rates. We may have to compete with these higher rates just to keep our lenders onboard and avoid a major meltdown. I'm old enough to remember the "spike" in interest rates that occurred in 1987. It was just before the stock market lost 25 percent of its value in one day.
More on the future of interest rates, but first let's review the bond basics.
Bonds are essentially loans to companies, or to the government, in return for interest payments. The payments continue until the bond matures, and then the original amount of the loan (the face value) is returned to you, the lender. Bonds can fluctuate in value and are valued every day -- just like stocks.
The value of an "old" bond depends on the interest rate it pays, and how that rate compares with rates currently offered on new bonds.
If interest rates in the new bond market rise, and the interest paid on an older bond is lower, then the value of that bond (if you wanted to sell it) would be lowered until its interest rate was arithmetically equal to the rate paid by new bonds. On the other hand, if interest rates plummet in the open market, your bond paying the older higher rate will suddenly be worth more than its face value.
Imagine a pulley and a dangling rope. If you tug the interest rope down, the value rope goes up. and vice versa. Eventually, however, the loan period ends and the original value of the loan (bond face value) is paid back. As you approach that pay-back time, the pulley effect exerts less and less influence because the remaining time period is too short to matter.
So, here we are with rising rates all of a sudden. Over the past three years, the rate has risen from 4 percent to 5 percent. If you bought a 10-year bond back in 2004 that paid about 4 percent, it is now competing with this week's new bonds that pay 5.25 percent.
Therefore, your old bond will have dropped in value by about 20 percent, but fortunately you only have to hold it for seven more years to get your full face value back. The recent 20 percent loss will claw it's way back to respectability as you approach the pay-back date.
What we have just described is what prompts foreign governments and other investors to demand higher interest rates before they will buy more of our U.S. government bonds.
To sell our bonds, we have the compound disadvantage of a falling dollar, falling bond value because of rising interest rates, competition from other governments selling bonds that pay higher rates and that are denominated in stronger currencies.
This could be a problem. Warren Buffet, in his latest annual letter to stockholders, points out his concern about the extent to which America has leveraged itself and subjected future generations to what could be huge costs of spiraling interest on national debt.
He says, "I believe that at some point in the future U.S. workers and voters will find this annual 'tribute' so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict -- but to expect a soft landing seems like wishful thinking."
One man's meat is another man's poison. Rising interest rates can be a good deal for retirees or people who don't owe much money and who are looking for income from investments.
Bonds with relatively short periods until they mature (like three years or so) don't experience much "market rate risk" such as I described above. If you have some bond mutual funds that have dropped in capital value, just be patient. Every day they will be replacing maturing bonds with the new higher interest bearing bonds and the income stream from interest payments will gradually rise.
As to what this all means for the future of the economy and the stock market, all we can do is grip the arms of our chair as hard as we possibly can.
You can generally disregard anyone who purports to know the answer.