What Moves Mortgage Rates? (The Basics)

Full Article: Show: Summary
 

Note: This is a very simplified discussion of a very complex topic. Discussion of the intricate relationships involved, and many important factors (market structures, hedging, advance commitments, and others) haven't been included in the text in order to (hopefully) make it useful to the greatest number of people.

What Moves Mortgage Rates? (The Basics)

Copyright HSH® Associates. All rights reserved. Contact us regarding reproduction of this article.

The questions are simple enough: What's going on with mortgage rates?

What makes them rise, or fall? Is it the Fed? The economy? Inflation? The banks? The President? Fannie Mae or Freddie Mac? Is it a secret conspiracy?

The answer is that rates are moved by a number of related factors, and believe it or not, you -- Joe or Jane Consumer -- are one of those factors.

Mortgage money can come from many sources, including deposits at banks and brokerages, but most comes from investors through what is collectively known as the "capital markets." This is where investors interested in purchasing certain kinds of debt instruments -- bonds, in this case -- come to buy these items.

In order to attract investors, sellers of bonds must compete with one another to get their money. They do this by offering a variety of " instruments" (also called "product") with differing structures of risk and return over given periods of time. These offerings compete with other investments which are reasonably similar in performance, such as US Treasuries, corporate bonds, foreign bonds, and others.

Who are these investors, and why are they so fickle? Mostly, they're people like you, and you want two opposing things: low payments on your debt, especially your mortgage, and high returns on your investments. You (or your investment advisors or fund managers) will only buy so many low- yielding bonds (mortgage or otherwise), because you'll take your money elsewhere if your returns are too low.

Investor demand for a given kind of investment plays a considerable role in moving market yields, because investors have literally hundreds of places to put their money. It's a crowded marketplace, with many sellers of various product competing for those investor dollars. Investor demand for specific product rises and falls with changes in investment strategies; if demand falls enough, a change needs to be made to attract investors again. How to attract them again? Usually, by raising interest rates.

Of course, it's not as easy or simple as that. Mortgage market makers serve not one client, but two: investors, who want the highest possible return on their investments, and the homeowner or homebuyer, who wants the lowest possible interest rate. Simultaneously, rates need to be high enough to attract investors but low enough to attract borrowers. It's quite a complex dance; investors, though, make the music.

As interest rates (yields) decline, investment customers can become more or less interested, depending upon the direction of economic growth, inflation, appetite for the given product, and several other factors. Typically, though, the lower those rates get, the fewer investors are interested in putting them on their books.

In the case of financial instruments like bonds, things get a little more complicated. Bonds have an interest rate (yield), a dollar amount (face) and a current price (price).

A very simple explanation -- which leaves out a number of very important factors -- would be as follows:

Let's say, for example, that you want to sell a $1,000 (face) bond with a yield of 6%. And let's say that it's a good deal, so ten investors start offering you more than the $1,000 you want. They bid the price up to $1,010 -- $1,020 -- $1,030. In effect, that increase in price is actually borrowing from the interest which the bond will return. Because some of the interest is gone, the actual return to the investor is no longer 6%, but something less than that. When demand for a given bond is strong, prices rise to the seller, and the return to the investor (yield) declines.

Conversely, when demand for a given bond is weak, the price falls. For example, you might have to sell that $1,000 for only $980; and the return to the investor (yield) rises, since the buyer not only gets all the interest on $1,000, but also got a discount on his purchase price.

The principle to remember is this: as a bond price rises, its yield falls, and vice-versa.

Relationships to Other Investments

Mortgages are priced for sale to attract investors who seek fixed income investments. There are many kinds of bonds available, and mortgage rates (yields) rise and fall with those competing investments to a greater or lesser degree.

But how to price them? Fixed mortgage rates, like other bonds, track US Treasury bonds quite well. Since Treasury obligations are backed by the "full faith and credit" of the United States, they are the benchmark for many other bonds.

There is no specific "lockstep" relationship between Treasuries of any term and fixed mortgage rates. Given enough data points, a relationship could be established against many different financial instruments. However, as a 30-year fixed rate mortgage rarely lasts longer than about 10 years before being paid off or refinanced, the closest instrument which has similar (though lesser) risks is the ten-year Treasury Constant Maturity. Because of this, the ten-year year Treasury makes an excellent tool to track mortgage rates.

Here's an oversimplification of the relationships of mortgages to Treasuries:

As we mentioned, intermediate term bonds and long-term mortgages (more properly, Mortgage-Backed Securities, or MBS) compete for the same fixed-income investor dollar. Treasury issues are 100% guaranteed to be repaid, but mortgages are not; therefore mortgages carry more risk of default or early repayment, which could potentially disturb the return on the investment. Therefore, mortgage rates must be priced higher to compensate for that risk.

But how much higher are mortgages priced? In a normal market, the average "spread" or markup above the 100% secured Treasury is about 170 basis points, or 1.7%. That markup -- the spread relationship -- widens and contracts with a range of market conditions, investor appetites and supply of available product -- as well as the presence of competing investment opportunities, like corporate bonds or domestic (or foreign) equity markets. Professional money managers, and investment and retirement funds constantly strive to obtain high-yielding instruments at a given level of risk. Money shuffles from place to place in search of this -- from bond to bond, and market to market.

As we mentioned, the relationship isn't a fixed one, but one that changes with market conditions. Recently, for example, ten-year Treasuries rose from a low of 4.22% to 5.01% over a three-week period -- about 80 basis points, altogether. At the same time, the average 30-year fixed mortgage rate rose from about 6.59% to 7.21%, a rise of only 62 basis points. Over time, there are any number of examples where Treasury yields have risen faster than mortgage rates, as well as times when mortgage rates rose faster than Treasury yields. Consequently, the spread between the two expands and narrows appreciably, which is why you can't simply take the ten-year yield, add 1.7% to it and know exactly what today's rate is.

An update, in light of more recent market events

All of the above text assumes for the most part that we are in a fairly normal marketplace. It goes without saying that mortgage and bond markets have been far from normal in recent months.

At present we remain in a very abnormal market.

There has been a tremendous move from "risky" assets, such as mortgages, into "safer" assets such as Treasuries. In fact, there has been so much demand for safety -- so much money pouring in to them -- that the effective yield for many Treasury offerings is near 0%, and where there are yields they remain near record lows.

This means that the difference between a "risk-free" 10-year Treasury and "risky" 30-year fixed mortgage rates is extraordinarily high. These are the wide 'spreads' you may hear referenced in popular financial media. With spreads so wide, for example, the 10-year Treasury yield might rise a huge amount -- perhaps as much as half a percentage point -- but have ultimately little effect on mortgage rates.

What would happen is such a case would be "spread compression", that is, the difference between the 10-year Treasury and mortgage rates would narrow somewhat. In fact, some investors might sell holdings of Treasuries and buy mortgages instead, so the rates on one might rise while the rates on the other might fall (or, more likely, hold pretty stable). This can happen as long as spreads remain wide and the relationship between the two instruments remains distorted, and means that the influence of Treasuries on mortgages is rather weaker than it has been in years. As such, moves in Treasuries one way or the other might not be fully (or even partially, at times) reflected in the going rate for 30-year mortgages.

Another overarching factor affecting mortgage rates are programs operated by the Federal Reserve. Three individual market-support mechanisms are manipulating mortgage prices to the benefit of borrowers.

Chief among them is the Fed's ongoing purchases of Mortgage-Backed Securities issued by Fannie Mae, Freddie Mac and Ginnie Mae (FHA loans). The presence of a large, unwavering buyer in the market serves to help stabilize interest rates by keeping the entire system liquid and flowing. A total of $1.25 trillion will ultimately be committed to their program.

Aside from selling MBS to raise cash, Fannie and Freddie also issue debt. With the firms' financial positions quite weak, their borrowing costs would normally skyrocket, since few investors would want to hold these "risky" bonds. To assist those firms, the Fed has committed to purchase up to $200 billion of their bonds, helping to keep their funding costs low and cash readily available, no matter what private investors might do.

At the same time, the government is issuing huge blocks of debt to pay for support and stimulus programs. Such a glut in the supply of debt is often enough to overwhelm investor demand. In such cases, yields (and mortgage rates) would rise in order to entice folks to purchase these instruments. However, the Fed has enacted a program to buy up to $300 billion in Treasury obligations, and so can act as a sponge during times of insufficient demand. This serves to help keep rates lower than they otherwise would be while also promoting stability.

Other Factors

Then, there's the "unknown supply stream", aka "volume". Unlike many other investment opportunities, no one really knows how many mortgages will be originated, then made available for sale (as bonds) in a given period of time. Recently, a quick drop in interest rates produced a large buildup of loans to be sold to investors as homeowners rushed to refinance. This made way too much bond supply available in too short a time, and investors simply couldn't absorb it all at once. Too much supply, not enough demand; prices had to go down, and yields had to go up to attract investors.

Delays, Delays

There's also a time-lag for mortgage pricing. Though shorter than in years past, it takes anywhere from several hours to several days for increase or decreases to get from capital markets to wholesalers to retailers to "the street" where loan originators are working with you.

Not all increases or decreases are passed along, either. Depending upon the size of the change, rates may stay the same (but fees, such as points, may change). Sometimes, a minor increase in bond yields in the morning is followed by a minor decrease in the afternoon, while mortgage rates remain the same all day.

Other Risks

There's also the impact of inflation, which affects both Treasury, mortgage and other fixed-income investments. Rising inflation reduces the actual return on a fixed interest rate investment, so with 2% inflation, that 6% mortgage note returns only 4% "real" interest.

If inflation is expected to decline for the foreseeable future, you can bet that mortgage rates have some room to fall. Conversely, an outlook which suggests higher inflation ahead will see mortgage rates rise, sometimes very quickly.

Also, a poor economic climate affects mortgages much more profoundly than Treasuries. After all, the US government isn't likely to lose its job and suddenly stop making payments, but it's a safe bet that a percentage of homeowners will, even in good economic times.

There's much more to the structure or bond, mortgage and capital markets, including government influences and overseas relationships to our capital markets which can also have an effect, but the above should be enough to give you a modest working knowledge of the market. You'll notice that so far, we didn't mention the Fed at all. Fed moves have no direct effect on fixed rate mortgage pricing, but their action or inaction (and expectations thereof) can indeed have indirect effects.

The Fed's Role

Contrary to popular myth, the Fed (more properly, the Federal Reserve) doesn't control mortgage rates. (For more on this, click here.) In fact, their most well-known policy tool -- the Federal Funds rate -- is the overnight interest rate which banks charge each other when a bank needs to borrow money to meet end- of-day reserve requirements. Simply, those rules say that a bank must have so much cash on hand when the books close at the end of the day, and those funds can be borrowed from another bank at this interest rate. You should know that the Fed merely "suggests" what that rate should be, which is why it's called a "target" rate; the actual rate is negotiated between the borrower bank and the lender bank.

A good way to keep a handle on the Fed is to remember that the Fed Funds rate is the shortest of short-term rates -- literally, an overnight loan -- and a fixed-rate mortgage is all the way at the other end of the scale, a loan that lasts as long as 30 years.

From Fed Funds moves, there's a complicated discussion of monetary policy about how Fed moves affect certain deposit and loan markets and inflationary expectations. We'll leave that for another article.

The end result is that the Fed raises or lowers interest rates to help address increases or decreases in economic activity. Lower rates can help banks to make certain kinds of loans more cheaply, especially for business and certain kinds of consumer lending, and that can help to generate greater economic growth. Higher rates can cool demand, helping to keep inflationary pressures from forming.

In some ways, expectations of what the Fed might do can be more important than what the Fed actually does, as their actions or inactions can help to confirm or deny what investors believe.

You may also have noticed that sometimes the Fed cuts interest rates -- and fixed mortgage rates actually rise as a result. Why? If the Fed is taking steps to address economic weakness by lowering rates, that likely means that a return to faster growth -- and possible higher inflation, as well -- is coming sooner, rather than later.

So what moves mortgage rates? Supply. Demand. Competition for money. Inflation. The Economy. Expectations. And you, of course.

We hope that this helps you understand a little better how the whole thing works.

Comments

Got something more to say about this topic? Feel free to submit your comments. (All comments are reviewed before posting.)

Thanks for your input!

Did you like this article? Let us know!

Copyright 2005-2008, HSH® Associates. All rights reserved.
Contact us regarding reproduction of this article.

HSH Associates, Financial Publishers
237 West Parkway
Pompton Plains NJ 07444
Phone: 800-873-2837 | 973-617-8700