Are Historically Low Mortgage Rates Gone for Good?

First of all I would like to acknowledge those that lost their lives on September 11, 2001 and the loved ones they left behind.

Since July of this year as the 10-year treasury yield has climbed mortgage rates have followed suit. As mortgage rates are a function of the 10-year treasury yield, when treasury bonds sell off and their yield climbs mortgage rates typically climb as well. To contemplate why mortgage rates might come down in the future it is important to understand why they have moved higher in the present.

Why Have Treasury Bonds Sold Off?

Although the Federal Reserve controls short term interest rates it has little direct control over long term interest rates. The Federal Reserve raises and lowers the Federal Funds rate, the rate that banks lend to each other for overnight loans. Long term rates are a function of those short term rates plus a "premium" for tying funds up over a longer period. The plot of interest rates over time is known as the yield curve. The "normal" yield curve is upward sloping with long term interest rates higher than the short term rates. This curve reflects a healthy economy where future economic prospects are good and higher long term rates reflect the markets belief that the Fed will raise rates to control prospective inflation. However, on occasion the yield curve becomes inverted where short term rates are higher than long term rates. This yield curve typically indicates a weaker economy as economic prospects are dim. Current economic data points to an improving economy. Money managers and analysts suggest this as the reason long term interest rates are climbing. This may be one reason but it may not tell the whole story.

The speed at which rates have gone up suggests a stronger reason for the rise. The debate between popular analysts on TV whether rates can stay low for much longer is a reflection of money managers shifting funds away from fixed income to other asset classes, in many cases equities. As bonds are sold their yields rise. Bond price and yield have an inverse relationship. The opposite is also true. If bonds are purchased their price rises and their yields fall. So what would cause the sentiment among money managers and the general investing public to change regarding the outlook for bonds? If the economic outlook for the US and global economy were to deteriorate money managers will seek the safety of treasury bonds.

So What Direction Are Rates Likely To Go?

Depending on your outlook for the economy, you will either believe rates will stay elevated and keep rising or will fall back down to their historic lows. Most analysts suggest that rates are capped and will not rise much further and going forward may even fall back. The logic behind the cap is the historical spread between the Federal Funds rate and the 10-year treasury, which has never exceeded 400 basis points or 4.0%. Given the tepid economic growth both in the US and abroad it's hard to believe that rates will continue their rise. The traditional bond spread suggests a cap of 4.25% on the 10-year treasury and therefore a mortgage rate for a 30-year fixed rate loan of about 6.80% which is roughly 230 basis points above todays rate. The argument for rising rates is continued economic strength, which is unlikely. Current levels of unemployment and lower levels of consumer credit do not indicate an environment for greater economic acceleration. The argument for falling rates is weaker economic growth which is also unlikely. An improved real estate market and rising equities values continue to increase the wealth of average Americans. So where does that leave mortgage rates? Rates are probably range bound at this point. As the 10-year treasury yield trades between 2.50% and 3.00% mortgage rates will trade accordingly between 3.90% and 4.60%.

Will We Ever See Rates Back At Their Historic Lows?

For mortgage rates to fall back to their historic lows, the US economy would have to enter a recession, which is on the low end of probability. It is certainly possible. What is more realistic and probabilistic is that the economy slows from its current pace without entering recession and rates fall back close to their lows. This would actually qualify as almost catastrophic, not wanting to speak in hyperbole. The Federal Reserve would almost have to consider their efforts to rejuvenate the economy a failure after spending trillions of dollars with such low growth as a result.