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What's Behind the Interest-Rate Spike?

Bond yields have jumped—and Wall Street is spooked. BW's Peter Coy explains what's causing the moves and what they could mean for the economy and markets

What's happening?

An era of exceptionally low interest rates seems to be ending. Rates are rising across the globe, in the U.S., Europe, China, New Zealand, and even ultra-low-rate Japan. On June 7, the yield on the U.S. Treasury's 10-year Treasury note zoomed to 5.1%, its highest since last July.

Why are rates headed up?

Although U.S. economic growth is sluggish, most of the rest of the world is booming and central banks are worried about inflation picking up. So they're raising rates to cool off their economies. Long-term rates rose in the bond market after the European Central Bank raised its refinancing rate a quarter point on June 6, to 4%, even though the move was expected. They were pushed even higher after New Zealand's central bank unexpectedly raised rates on June 7. The Bank of England has left the door open to further rate hikes, and the U.S. Federal Reserve maintains a "bias" toward raising rates rather than cutting them. So higher rates are very much in the air.

Is inflation really something to worry about?

Yes. Whenever most of the planet is growing at a fast clip, there's a danger of bottlenecks forming. Strong demand has driven up the prices of commodities like oil, for one thing. Low unemployment could give workers leverage to demand higher wages and salaries. In the U.S., the markets were spooked when the government announced that unit labor costs—the cost of producing a unit of output—rose at an annual rate of 1.8% in the first quarter, above the initial estimate of 0.6%. And higher rates abroad put downward pressure on the dollar's value, which raises import prices and thus adds to inflation.

But is inflation a problem now?

Not so much at the moment. Inflation, while slightly higher, remains well contained so far, in part because price-setters are confident that central bank vigilance will keep prices from getting out of hand. For example, in April the Fed's favorite measure of inflation, the core personal consumption deflator, rose a tiny 0.1% and was up just 2% from a year earlier. That meant it was at the top end of, but not above, the Fed's target range, notes Alexander Paris, president of Barrington Research Associates, a Chicago-based brokerage firm. Another favorable sign is that market expectations of inflation, as revealed by the spread between ordinary Treasuries and inflation-protected securities, remain well below year-ago levels.

Why is the U.S. stock market falling?

It was vulnerable to any kind of bad news after a long string of record-breaking closes. Higher global rates are bad for U.S. stocks for two reasons: First, higher yields on bonds in the U.S. and abroad make them an attractive alternative to stocks. In fact, stocks that have high-dividend yields (and thus compete most directly with bonds), such as utilities, suffered some of the biggest hits on June 7, when the Dow Jones industrial average tumbled about 200 points. Second, higher rates could eventually pinch corporate profits by slowing economic growth. Take the Standard & Poor's 600-stock index of small-cap stocks. Even if those stocks meet expectations for profit growth this year, their price-earnings ratio is pretty lofty for a world of bond yields over 5%, says Keith Hembre, chief economist at Minneapolis-based First American Funds, which manages more than $100 billion in mutual fund and institutional assets. Hembre says he remains optimistic in the medium term, but says higher rates are "going to pose a pretty meaningful challenge" to the stock market in the short term.

What's the chance that the Federal Reserve will copy other banks and raise rates?

For now, still extremely small. It's almost guaranteed that the Fed will leave rates alone at its meeting later this month. The market is betting that that there's only a 2.2% chance of a rate hike at the August meeting and a less-than-6% chance of a hike in September. That's based on a Bloomberg Financial Markets analysis of fed funds options and futures trading. Yes, Fed Chairman Ben Bernanke has been reminding people that the Fed's more worried about inflation than a slowdown, but the most likely course for the Fed is to leave rates unchanged for some time to come. Raising rates now, while the economy is still being dragged down by the housing slump, would endanger the expansion.

Coy is BusinessWeek's Economics Editor.

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