Thursday, January 29, 2009

Window closing on sub-5% mortgages

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.


Anonymous said...

Greetings, Scott. Is this an example of the government's inability to control long-term rates? Presumably, a component of the TARP intervention was to artificially lower mortgage rates (specifically, 30-year) in order to stimulate real estate activity. Are there other methods the administration might try, or are they fighting an uphill battle against real-world market forces?

Scott Grannis said...

I've always believed that the Fed had no ability to directly control long-term interest rates. Indirectly, yes, by pursuing good policies (for lower rates) or bad policies (for higher rates). Overtly easy monetary policy may fool the market for awhile, but not for long. Already we are seeing a steeper yield curve, as long rates rise much more than short rates. In the final analysis I don't think there is any way the govt can manipulate long-term rates by either keeping short rates low or by buying long-term bonds. The market is too big.