As an alert reader suggested several days ago, the window of opportunity to lock in sub-5% mortgages is closing as 10-year Treasury yields jump. There is a perverse dynamic in the bond market that accentuates swings in bond yields, and that dynamic is now kicking in with a vengeance, and that in turn could propel yields much higher in the next few weeks. This dynamic results from the ability of homeowners to refinance their mortgages with relative ease. As yields fall, the incentive to refinance rises. When yields plunge, as they did recently, there is a stampede of homeowners seeking to refinance. Indeed, refinancing activity rose by a factor of 7 between the end of November and early January. Now, with yields rising, refinancing activity is rapidly slowing.
Bond investors don't like to hold mortgage-backed securities (MBS) when yields are falling, because the duration (the responsiveness of MBS prices to changes in yields) drops. To compensate for this, they will typically buy 10-year Treasuries in an attempt to add back duration to their portfolios as yields decline. Thus, falling yields result in increased demand for Treasury bonds, which helps yields decline even more. We're now seeing the reversal of that: yields are rising and the same bond investors who recently were scrambling to buy T-bonds to add duration to their portfolios are now rushing to sell. And that puts more upward pressure on yields, in a form of vicious circle. If the current episode plays out like the last one did, in mid-2003, then yields could rise at least a hundred basis points more in fairly short order.