What happened to mortgage rates?

06.11.09
By Randy Johnson

Earlier this year, mortgage rates hit the lowest mark since Freddie Mac started charting them in 1971. With rates firmly in the 4 percent range buyers have entered the market, lured by lower home prices and low rates. Refinance activity has left lenders terribly backlogged. Sales of homes in the re-sale market have increased for three straight months.

Then last week the market jumped significantly, as the information below indicates. This graph plots the rate on 30-year fixed-rate mortgages and the yield on the 10-year Treasury bond. During this period, mortgage rates averaged 2 percent over the corresponding T-Bond yield. To make the graph more meaningful, I added 2 percent to the T-Bond yield. This keeps the lines in the same portion of the chart.

What is immediately obvious is that T-Bond yields have been rising steadily all year long from a low of 2.4 percent to 3.7 percent today. During this same period, mortgage rates have stayed in the same range – that is, until this last week. What happened, and why?



If you looked at a graph of these same data over the this decade changed, you would see that mortgage rates and bond yields track each other very closely – not what we see here. So when you see this divergence you would expect that one of two things would happen. First, T-Bond yields could fall back to the normal spread, falling back, say, to 2.5 percent.  

The alternative is what really happened. Buyers of Fannie Mae’s and Freddie Mac’s mortgage-backed securities (MBS) considered alternative investments in T-Bonds to be more attractive and they demanded higher rates on those MBSs. Mortgage rates had to rise.

The other thing  that happened is that about three months ago, both the Federal Reserve and the  Treasury Department started buying Fannie Mae’s and Freddie Mac’s  mortgage-backed securities.  They bought over $800 billion worth and by being in the market at that volume, they set the market rate.  When the 800-pound  gorilla is in the room, you do what he wants. In this case, the rest of the  market played along and mortgage rates stayed below 5 percent.  When the gorilla  left the room, other market forces took over. The yield at  yesterday's Treasury auction of 10-year Bonds was 3.99 percent, up  dramatically.

But everyone in the world knows that the U.S. is running a massive deficit. In the current fiscal year started October 2008, the current deficit is some $804 billion. The deficit is projected to more than $1.752 trillion. The current national debt stands at over $11 trillion, and during the next couple of years it is going to rise faster than at any other time in our history.

People who buy Treasury bonds are not oblivious to the fact that with the government’s current rate of deficit, dollars are likely to be worth less and less. Therefore they want more interest to make up for that. That puts upward pressure on rates.

I suppose that what everyone in Washington hoped for was that no one would call them on this for a while. They could keep short-term rates low by keeping the Discount Rate, currently at .25 percent, very low. They could keep long-term rates low by being a buyer of long-term securities, as they have been doing. If they were able to keep it up long enough, the housing market would heal and the rest on the economy could start its recovery.

What has happened, however, is that the bond market called their bluff.

Where we go from here I do not know. But I do not believe that normal market forces can get mortgage rates back below 5 percent again. It will take more government intervention in the market. Rates are still low enough to keep homebuyers interested in buying up properties, including the million foreclosed homes on the market. But refinance activity will come to a screeching halt. With rates below 5 percent, there were a lot of people with 6 percent mortgages that found refinancing advantageous. But refinancing is just not as attractive with rates well above 5 percent, and that business dries up.

Maybe that’s okay, because selling those homes and getting back to a normal real estate market is important. If several million people can’t refinance, too bad; economic recovery is not dependent upon them reducing their mortgage payment. We need to be more aggressive about helping people who are underwater and who are about to lose their homes, and those actions are not dependent upon keeping rates as low as they have been.

Stay tuned.  

For those who are interested in following the market more closely, you can track bond rates easily at Yahoo Finance. In the GET QUOTES box put ^TNX. You can follow mortgage rates at Freddie Mac.

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Are the days of mortgage rates below 5 percent gone for good?