From a very early age we learned the basics of “cause and effect”. If we did “this” then “that” might occur; sometimes we might have thought that a certain act caused a certain result but through more experiences we learned to decipher what caused what (for the most part). The mortgage market -and every other market- is no different; there are economic factors and occurrences that dictate mortgage rates, and ultimately ,greatly influence the Real Estate Market. Make sure to read Part I and Part II in order to get the most out of this article.
In recent years economies and markets have become more global than ever. Improvements in technology and communication have directly influenced the flow of capital and relatively easy access to markets. A common investor in the U.S. has access to any stock exchange in the world and can invest in any asset type available; whether it be directly or indirectly through a fund.
The asset prices are determined by the supply and demand of each asset. For the most part, the riskier the asset the higher the return; so, historically a 10 year Treasury Bill will yield less return than lets say a corporate bond issued by a “junk” rated company. The MBS’s prices are a huge factor in determining the rise or fall of mortgage rates. Therefore as demand rises and falls, MBS prices fluctuate and so do mortgage rates.
It’s important to go over the basics of a bond, given MBSs are bonds. For a fixed rate security (bonds) price and yield are inverse, meaning they move in opposite directions. For example, if a bond with a face value of $1,000 has an annual coupon rate of 9%, it pays $90 in interest. If you purchase the $1,000 bond for $1,000 (or par), then $90 in interest yields 9%. However, if you can get the same bond for $900, the yield becomes 10%. So you purchased the bond at a discount; this usually happens when the bond rating is downgraded or there are other factors that speculators believe will cause the bond guarantors to default on their payment, therefore making the bond worthless. While this is happening behind the scenes (in the secondary market) ; borrowers see this reflected through “discount points” charged during origination in order to obtain lower rate mortgage loans – to make up for the lower return. As the price gos down, the yield increases. This is the mechanism through which price changes for MBS determine mortgage rates.
Now that we understand the relationship between MBS and mortgage rates, I would like to present the two most important economic factors that impact interest rates; these are “economic growth” and “inflation”. The faster the economy is growing, the more demand there will be for capital, leading to a higher cost for borrowing money. That’s why often times, when the economy is doing well, it boosts stocks but sinks bonds and MBS prices (cause interest rates to rise). Inflation increases when growing economic activity adds to demand for all types of resources.
The value of the dollar is eroded by inflation, which translates to lenders demanding more dollars back at a later date to compensate for the lost purchasing power. Side note: That is why you technically “lose” money when you leave it sitting in a savings account, because the savings account pays you around .002% and the average inflation rate is about 2% annually. So, the investors that hold mortgage programs that have a fixed rate for the life of the loan are at greater risk during a high inflationary environment, which can seriously diminish an investment’s inflation adjusted return. At the time an investor purchases an MBS, the rate of inflation, must be predicted over the life of the loan. The investor will demand that the yield on his investment exceed the expected rate of inflation by enough to earn a reasonable return. As you all might have guessed, predicting what inflation will be for years in the future can be very difficult, and being wrong can be very costly. This is why MBS prices are so highly sensitive to anything that changes ones expectation of future inflation.
Now you are probably asking yourself, ok so what factors affect the two most important economic factors influencing mortgage rates? Well, throughout the day/month/quarter/year, there are many reports that provide information about the current level and expected level of economic growth or inflation. Sometimes there will be multiple reports published in a day or a week; that will cause great volatility to the MBS market. There are some economic reports with more significance than others.
Basic economics teaches us that the price of any product affects the supply or demand of said product which will in turn affect the price. So, why would an investor turn to MBS when there are so many options out there? Well, they do so to hedge their risks when equity markets look a bit risky. In times of political instability the demand is greater for these lower risk instruments, so a terrorist attack, for example, may produce a rally in MBS markets. Foreign central banks may have motives for purchasing securities which are different from investors who are assumed to be seeking to maximize their investment return. To balance foreign exchange transactions related to imports and exports, they may be forced to buy or sell US securities regardless of what they consider to be the best investment At times, investors simply want to protect their principal and choose to park their money in safe assets like US Government guaranteed MBS or Treasuries.
There have been a plethora of books written about the economic factors which affect different asset classes; and at the end of the day, even the most experienced investors and experts in the field will tell you that nobody really knows what the future holds; the best we can to do is use historically data to try to be in the best position to obtain the highest return.
I hope that these articles will give you an edge (knowledge) over other industry professionals. Please feel free to reach out to me directly, you can find my contact info on (insert contact page), I’ll be happy to expand on any questions you may have.