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Why US Investors Don't Need To Fear Higher Interest Rates

Few things can make investors run to the exits faster than the threat of higher interest rates. But there is little of that fear this time around.

Rates have been edging higher in recent weeks—and are expected to keep climbing—as the economy recovers, deficits soar and other factors push up borrowing costs.

Most analysts, though, think the move will largely be taken in stride by the markets. There's even sentiment that investors will greet rate hikes as a sign that the economy is safely on a stronger path.

"The economic recovery is boosting rates, and that is a positive," says Brad Sorensen, director of market and sector analysis at Charles Schwab. "We see no evidence that there are inflationary pushes other than the economy improving. That's not a bad thing for stocks or companies or corporate profits."

Investors often recoil at higher interest rates because that means it costs more for companies to borrow and thus eats into profits.

The Federal Reserve continues to indicate it will not be raising its key lending rate for an "extended period." But other key interest rates, such as the yield on the 10-year Treasury, are climbing, which is pushing up some consumer rates.

Because the increases are incremental, there is little fear that higher rates will derail the economy or quarterly earnings. When the Fed does eventual signal that rate hikes are coming, there could be a short-term pullback in the market, but analysts say it likely won't last.

Barclays Wealth projects the 10-year note to hit 4.50 percent by the end of 2010, a gain of about 0.70 percentage point from its current yield but not enough to a change investment strategy.

"The interest rate environment is favorable at least through the second quarter," says Brian Nick, investment strategist at Barclays. "There's a pretty strong consensus that rates are going to go up. But 4.50 from where we are now does not sound like a particularly dramatic move."

While most analysts favor a scenario of the 10-year note at 4.25 to 4.50 percent—which would put the mortgage rate, for instance, at around 6 percent—there are some wide disparities.

Goldman Sachs has pegged its projection at the low end of the scale with a 3.25 percent rate, while Morgan Stanley forecasts a 5.5 percent rate.

Morgan analysts also are far less sanguine, though, about the effects higher rates would have on the market. In a recent strategy outlook, the firm warned that investors could become spooked over the prospects of the Fed moving too fast on rate increases and pulling back other measures to aid the financial system.

Morgan Stanley strategist Greg Peters warned of a "disconnect between ever-firming economic data, steep yield curve, (and) higher back-end yields" and that markets were susceptible to a "policy mistake." The firm advised clients to sell when the market rallies and to buy high-quality companies and high-yield bonds.

The somewhat gloomier scenario, though, is not pervasive, though some think a murky interest rate environment could result in a correspondingly uncertain investing climate and tempered moves in both stocks and bonds.

"There's talk that the bond rally may be over. That may be true but it may not necessarily be a huge bear market," says Doug Roberts, chief investment strategist at Channel Capital Research in Shrewsbury, N.J. "This might just be a place where you don't get a huge amount of returns on your bonds, but you're in a place where they're kind of stable."

Some see other factors, such as inflation, as more indicative of what will happen than a simple look at interest rates. Right now, inflation remains virtually non-existent.

"If the economy is weakening or growth is moderating, you're unlikely to see a whole lot of inflation out there," says Tom Higgins, chief economist at Payden and Rygel in Los Angeles. "There's a cap on how much rates can rise. I don't think rates in and of themselves will be the primary factor limiting growth."

There also was fear that the government was going to have an increasingly difficult time selling its debt after the 10-year yield hit 4.01 percent recently. But subsequent Treasury auctions easily allayed those fears and the yield has since dropped, most recently trading at 3.87 percent.

"A selloff in the long end of the curve isn't necessarily going to spell doom for the equity markets," Barclays' Nick says.

And those who don't see rates hitting stocks also say they have history on their side even if the Fed does relent and start hiking rates. Barclay sees the Fed funds rate moving from near zero to 0.75 percent by the end of the year.

A Fed hike could see stocks fall, but only briefly, says Ken Fisher, president of Fisher Investments in Woodside, Calif.

"The history of three, six, 12 and 24 months after the first Fed rate hike is easy to measure, and it's overwhelmingly bullish," Fisher says. "It's overwhelmingly bullish because the Fed raises rates the first time when they think they can get away with it."