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What Moves Mortgage Rates? (The Basics)

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 of 3.30% to 3.94% over a period of a few months -- about 64 basis points, altogether. At the same time, the the average overall 30-year fixed mortgage rate rose from about 5.29% to 5.41%, a rise of only 12 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. It goes without saying that these 'spread' relationships vary by mortgage product and also by whether a loan will be held in a lender's portfolio or sold to other entities.

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 years.

It may be some time until we return to normal mortgage markets, fully free of extraordinary efforts by government, and where private-market investor needs shape the marketplace. That said, we are starting to move in that direction again.

A large influencing force in the mortgage market came to an end in April 2010, as the Federal Reserve finished its program of purchasing $1.25 Trillion in Mortgage-Backed Securities. Since the Fed not only bought new production from Fannie Mae, Freddie Mac and Ginnie Mae (FHA-backed loans) but also certain existing "agency" stock from investors, there remains in the market some momentum from the program, as investors look to re-fill holes in their portfolios with newly-issues, often better-quality mortgage investments.

At the same time, some additional holes in investor portfolios were created when Fannie Mae and Freddie Mac decided to re-acquire up to $200 Billion of previously-securitized-but-now-failing loans from investors, an occurrence allowed under the terms of the guarantees which accompany the MBS issued by these entities. Like a portion of the Fed program above, retiring these holdings means that at least some new private-market demand for newly-issues MBS should occur.

This increase in demand by investors for new MBS means that prices for those MBS should remain fairly firm for a while, which in turn means that low yields -- low mortgage rates -- should be with us for at least a little while, too.

So there should be at least some demand for new securities. What about supply... will new supply overwhelm the demand in the market? Probably not, at least for a while. With home sales well below peak levels, and even small flares in interest rates making sizable dents in the refinance market, the number of new loans coming into these security machines isn't all that strong, so there shouldn't need to be a cascade of supply into the market. Better still, even if demand for MBS doesn't remain constant, Fannie and Freddie have considerable space to balloon their portfolios of loans (upstream of turning them into securities) and so can release new MBS supply into the market at a measured pace, which should also serve to stabilize prices, keeping rates level.

In a nutshell, the Fed may have stepped away from the mortgage market at the time, but there were still different mechanisms in place which should have much of the same effect of keeping rates fairly low and steady, at least for a time.

Of course, the above programs ultimately gave way to to the Fed's "Operation Twist", where the Fed recycled money created by selling certain short-term debt it held and buying more long term bonds, while also using the proceeds from the mortgages it owned to buy new mortgages. This lowered both long-term interest rates and mortgage rates for a while, but when the Fed began to run low on short-term holdings to sell, it had to come up with something new. As such, when Operation Twist came to an end, and with the economy still not fully healed, the Fed began the so-called QE3 program, where they were again directly purchasing both Treasury and Mortgage Bonds to keep rates low and plenty of mortgage money available. This program ended in a gradual tapering of purchases before coming to conclusion in October 2014, but the Fed decided to keep reinvesting inbound proceeds from maturing and refinanced holdings and indicated that they would until "policy normalization is well under way." Reinvestment has been the case since October of 2014; however, with increases in the federal funds rate in December 2015, December 2016 and March and June of 2017, we are approaching "well underway", and so in June 2017 the Fed announced a program to begin to slowly trim some holdings from its $4.2 trillion portfolio.

A gradual reduction in the amount the Fed will reinvest each month ($6 billion for Treasuries, $4 billion mortgage debt) will be increased in like-sized amounts every three months until reaching a maximum of $30B and $20B, respectively. As such, this process will start slowly, most likely in late 2017, and accelerate to full speed over a years' time. The expected timeline to completion is perhaps three years or more, and analysts expect the Fed to want to retain as much as $2.8 trillion for policy purposes when all is said and done. Although designed to have a limited effect on mortgage rates, perhaps raising them 20 or so basis points than they might otherwise be, there's no way to know if this will always be a smooth operation with only modest effect on rates. Private investors can be fickle and mortgage bonds may or may not be a favored investment at any given point in time, so the effect on rates may be more pronounced during intervals of market stress.

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 Traditional 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.


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Copyright 2005-2017, HSH® Associates. All rights reserved.
Contact us regarding reproduction of this article.

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