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As long-term rates have climbed in recent months, mortgage rates have followed suit. The cost of a 30-year conventional mortgage is now at about 4.7%, up from 3.6% in early May, and the monthly mortgage payment on a median U.S. house has increased roughly $200 during the same period.

As mortgage costs have risen, mortgage and sales activities have started to drop. A recent MBA survey has loan activity down by more than 50% from a May peak and July new-home sales plunged, experiencing the biggest drop in three years. But rising rates may not just hurt the housing market, they could also hurt the U.S. recovery through their impact on the housing market.

As I write in my new weekly commentary, the housing market is critical for the U.S. recovery. When bond yields fell somewhat last week following news of the 13.4% drop in July new-home sales, the importance of the housing market to the recovery was tacitly acknowledged (a weaker housing market implies a weaker economy and a less aggressive Federal Reserve).

If steeply rising rates cause the housing market to roll over, the economy is likely to go with it. Housing drives new construction. And perhaps more importantly, recent higher home prices have been supporting consumer confidence and consumption. Even in the absence of disposable income growth, consumers have been more inclined to spend as their paper wealth has increased along with rising housing prices, a phenomenon known as "the wealth effect." Confidence and consumption could suffer, however, if housing prices decrease along with a housing market suffering from quickly rising rates.

The good news is that I expect that interest rates, and mortgage rates by proxy, will continue to increase at only a modest pace. The Fed knows that the recovery is still tepid, and higher rates will slow it further. In addition, the majority of a near-term adjustment in rates ahead of a likely fall taper has already taken place.

But there is the risk of rates rising faster than I expect. If frustrated investors start to aggressively sell bonds, long-term rates could go too high too fast, endangering the housing market and the recovery. In this environment, I continue to advocate that investors should:

  1. Expect more volatility.
  2. Consider overweighting stocks relative to bonds. While stocks and bonds are likely to remain volatile in the near term, assuming inflation stays muted and the rate rise is gradual, I believe that stocks will likely do a better job of withstanding rising rates than bonds.
  3. Remain cautious of segments of the equity market vulnerable to rising rates, including utilities stocks and consumer discretionary companies, especially those tied to the housing market, such as homebuilders.

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Source: Why Rising Mortgage Rates Matter For The U.S. Recovery