Q&A: Why rising interest rates are shaking financial markets

NEW YORK (AP) -- Well, that escalated quickly.

After rising steadily for much of the past year, Treasury yields got a shot of adrenaline this week, and the yield on the 10-year Treasury leaped to its highest level in seven years. It temporarily crossed above 3.20 percent during trading on Thursday, up from 3.05 percent late Tuesday.

U.S. Treasurys often act as the benchmark against which other investments are measured, and the surge in yields reverberated in markets around the world, prompting selling in both stocks and bonds. The S&P 500 had its worst day in three months Thursday, for example.

Here's a look at what's going on:

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WHY ARE INTEREST RATES RISING?

The U.S. economy is doing well, and the Federal Reserve is raising short-term rates in response. Last week, the Fed raised its benchmark rate for the third time this year, and the federal funds rate now sits at a range of 2.00 percent to 2.25 percent. It had been anchored at virtually zero for seven years following the 2008 financial crisis.

The Fed has less control over longer-term interest rates, which move mostly on expectations for future economic growth and inflation. Reports this week showing strength in the job market and services industry pushed up those expectations, and investors sold longer-term bonds accordingly. When a bond's price falls, its yield rises, and the 30-year Treasury yield touched its highest level in four years.

This week's market drama puts an even bigger spotlight on Friday's jobs report, which is traditionally the most anticipated economic report of each month. If job growth or wage inflation end up being much stronger than the market expects, it could lead investors to dump even more bonds and push rates still higher.

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WHAT DO RISING RATES MEAN FOR STOCKS?

Higher rates generally hurt stock prices for a few reasons. One is that higher rates make it more expensive to borrow, which can put pressure on corporate profits and tap the brakes on economic growth. Another is that higher yields make bonds more attractive investments, which can siphon buyers away from stocks.

In recent years, with bonds paying meager interest, investors had gravitated toward stocks with the highest dividend yields, such as utilities and real-estate stocks. Now, those income-seeking investors have incentive to move back into bonds. Real-estate stocks in the S&P 500 are down 2.7 percent so far this week, more than six times the 0.4 percent loss for the overall index.

But a push-pull effect is also taking place. Rates are rising because of a stronger economy, which should help corporate profits. That's giving some support to stocks.

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WHAT DO RISING RATES MEAN FOR BOND INVESTMENTS?

Bonds getting issued today are paying investors more handsomely than those issued a year ago. That's good news for savers and investors looking for more income.

But those bonds issued a year ago look less attractive in comparison. That means their resale price drops, something mutual funds and ETFs with such bonds in their portfolios must account for. Prices for long-term bonds are more sensitive to rises in rates than short-term ones, because they lock investors into a lower rate for a longer period.

As a result, bond funds have logged losses the last couple days, though generally milder than for stock funds. One of the largest bond funds, the iShares Core U.S. Aggregate Bond ETF, is down 0.8 percent since Tuesday, its worst two-day performance since February.

A swoon in bond funds can be particularly unsettling for investors because they're supposed to be the safe part of anyone's portfolio, offering stability when stocks go on another stomach-churning runs.

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SHOULD I PANIC ABOUT RISING RATES?

Not if the rise happens gradually.

For bond funds, higher rates are knocking down prices, but they should also eventually mean more income. If rates rise slowly, that higher income could offset the price drops and leave investors with positive returns.

For stocks, higher rates make investors less willing to pay high prices for each $1 in profits that a company produces, because bonds look like better alternatives. But if rates are rising due to a strengthening economy, corporate profits should also be rising, which could help the case for holding onto stocks.

The Federal Reserve has repeatedly pledged to raise rates only gradually. Last month it indicated it may raise rates in December for the fourth time this year, three times in 2019 and perhaps once in 2020.

The biggest threat to stocks would be a burst of inflation that causes the Federal Reserve to sharply accelerate that timetable.

"If we woke up tomorrow, and the 10-year was at 3.50 percent, it would probably mean it's there for bad reasons," said Brian Nick, chief investment strategist at Nuveen. "But if we wake up a year from now, and it's 3.50 percent, that's not as much a problem."