By Chris Muoio, Quantitative Strategist, Auction.com Research
This is the second in a two-part series. Read the first part.
In Mortgage Rates 101, I broke down what real estate mortgage rates consist of and why; how they can vary; and what the commonly quoted rate on TV really is. In this post, I’ll dive a little further into the biggest component of mortgage rates: bond yields. As I mentioned in my prior post, the reason that this is such a large component of mortgage rates is because banks borrow at a rate close to bond yields in the market and then lend to you at a higher rate, hoping to capture the premium.
As a result, mortgage rates tend to fluctuate with long-term government bond yields, following their market movements pretty closely, but not exactly. So if you’re thinking of buying a home and getting a mortgage, it’s important to have a basic understanding of bond yields so you don’t get caught staring at a much higher-than-expected mortgage rate that makes the monthly payment on your dream home unaffordable.
Long-Term Bond Yields Reflect Market Expectations
So what drives long-term government bond yields? Without delving into economic textbook math and the nitty-gritty of market mechanics, government bond yields are essentially a reflection of long-term inflation expectations for the U.S. economy. Inflation is the rate at which prices rise (or fall, in the case of deflation) over time. Inflation is driven both by short-term factors, like rising gas prices rising, and long-term factors like wage growth and the changing demography of the labor force.
In the case of long-term bond yields, long-term inflation expectations are the most important. In the U.S. economy, these are typically tied to wage growth and demographics. It’s also important to remember that the actual level of wage growth and economic growth is less important than the aggregate expectation; it’s the expectations that drive the movement in the markets.
So where does that leave us now, and where do we go from here?
As the chart above shows, bond yields have fallen steadily over the last several decades, and are currently at very low levels, bringing down mortgage rates with them. This has been exacerbated by the Federal Reserve’s recent monetary policy, which is designed to keep rates low in an effort to stimulate greater growth through improved bank balance sheets and lending.
Bond Yields are Low Now, but What’s the Fed’s Next Move?
So where are we heading? Well, that’s a multibillion-dollar question, and if you have the answer, I encourage you to stop reading and go open a hedge fund I can invest in so we can both retire. But for now, let’s just try to break down the different factors at play. Currently, bond yields are very low, because growth and inflation expectations for the U.S. economy are fairly low as well, thanks to a myriad of factors that include our demographics, lack of wage growth, and current Federal Reserve policy.
However, as you’ve probably read by now, the Fed is considering raising interest rates, and wage growth is beginning to show signs of percolation. Rising wage growth will raise inflation expectations, as wages are typically the driver of long-term inflation, so this should drive a rise in long-term bond yields.
Figuring out the Fed’s next action, though, is a little trickier. When the Fed raises rates, it’s raising a very short-term rate that determines the cost of capital for lenders. So to determine how a Fed rate increase will affect bond yields and mortgage rates, we have to account for the yield curve in our analysis.
The Yield Curve
When I said earlier that banks will borrow at a rate close to bond yields and lend to you, I was fudging things slightly. In reality, banks borrow at short-term rates, continuously rolling this borrowing over at short-term rates, and lend to you at long-term rates. Because short-term rates are typically lower than long-term rates, lenders can capture additional profit (which is called net interest margin on a bank earnings report).
Why are short-term rates lower than long-term rates? For the simple reason that there’s more uncertainty over the long term; more unforeseeable adverse events can occur. To mitigate the increased risk, banks charge more to lend over longer time periods than they would over short-term timeframes.
One of the problems that triggered the last recession was that banks became scared to lend to each other, because they viewed each other as large default risks. The short-term lending market dried up, which resulted in the massive economic downturn.
The short-term/long-term spread is called the yield curve, which in a healthy economic environment looks as it currently does, with short-term rates well below long-term rates. Banks can borrow cheaply in the near-term and roll this funding over (in a normal environment), while they lend for the long term and make more profits to lend or pay out to shareholders. It’s a virtuous cycle.
What Happens When the Fed Raises Rates?
So when the Federal Reserve “raises rates,” it’s raising very-short-term rates, the ones it controls directly and the ones at which banks can borrow. This can have two different results. The first is that the market takes this as a signal of improved confidence in inflation and growth expectations, and the increase in the short-term rate trickles throughout the yield curve, resulting in higher rates throughout. Long-term bond yields—and therefore mortgage rates—rise, as I described in my Mortgage Rates 101 post. This is the most likely scenario, because the economy remains healthy and growth expectations remain reasonable.
However, the other thing that can happen is that short-term rates rise but the market’s expectations for long-term inflation and growth don’t change, which results in the yield curve “flattening” as the spread between short-term and long-term rates narrows. Banks can become averse to lending, as it becomes less profitable for them and in turn might result in a higher-risk premium portion of the mortgage spread.
When this really becomes toxic, however, is if the yield curve inverts, and short-term rates rise above long-term rates. This is a sign that monetary policy is too tight and needs to be loosened through rate cuts or quantitative easing by the Federal Reserve. In this scenario, lending becomes a negative outcome for the banks because it costs more for them to borrow than they would make by lending, and credit becomes unavailable. This is what was called the “credit crunch” during the last cycle, and is actually one of, if not the most, reliable indicators for an impending recession, because it’s a real-time market signal of tight credit conditions and lending availability.
Since mortgage rates follow bond yields very closely, it’s important to keep in mind what drives them as you consider the timing of a home purchase. Currently, bond yields and mortgage rates are at multi-decade lows, signaling that it’s probably a good time to get a mortgage if you’re thinking of buying a home. The Federal Reserve appears to be on the verge of raising rates, and wage growth (and therefore inflation) is percolating, perhaps leading to higher bond yields in the coming years.
However, we’ve false-started on this path before, and the global economy is weak. Like I said earlier, it’s a multibillion dollar question guessing the path of bond yields and the yield curve, but right now the odds appear to favor getting a mortgage sooner rather than later.
