Mortgage watchers, such as yours truly, keep a close eye on the 10-year Treasury yield because when it moves, mortgage rates will follow. But lately, the 10-year Treasury yield has been an imperfect barometer, and that's made the art of predicting mortgage rates dicier.
Unlike rates on credit cards, auto loans and other consumer loans, fixed mortgage rates are disconnected from the Federal Reserve Board's interest rate moves. They rise and fall as yields on 10-year Treasury notes move. Why? Mortgages are often sold to investors, packaged together into bonds and issued in financial markets as mortgage-backed securities.
The yields and ultimately the prices for mortgage-backed securities and other debt instruments are priced at some interval to risk-free government debt. The 10-year Treasury is the relevant benchmark for mortgage-backed securities because the vast majority of 30-year mortgages get paid off in a time span of 10 years or less, as people move, refinance or prepay mortgages.
Mortgage rates have shot up the past two weeks. After the 30-year fixed mortgage bottomed at 6.02 percent two weeks ago, rates have rebounded sharply to 6.40 percent, the highest since July 31.
But the behavior of the 10-year Treasury notes has been different. Their yields have been particularly volatile in recent weeks, and although mortgage rates have jumped as well, the pathways aren't congruent. Yields on 10-year Treasury notes, which hit a 40-year low of 3.61 percent at market close on Oct. 9, have since rocketed to 4.24 percent as of Wednesday's close. Despite this jump of 63 basis points, mortgage rates have increased by a slimmer margin of 38 basis points, from 6.02 percent on Oct. 9 to 6.40 percent on Oct. 23. A basis point is one one-hundredth of one percentage point.
A similar phenomenon was seen when rates were declining so dramatically between July and October. Again, mortgage rates did not keep up with the pace of changing Treasury yields, only in this instance it occurred as rates dropped. Between July 30 and Oct. 9, the yield on 10-year Treasuries dropped an eye-popping 104 basis points, from 4.65 percent to 3.61 percent. Yet, mortgage rates fell by a less impressive 46 basis points, from 6.48 percent to 6.02 percent.
While mortgage rates and Treasury yields march to the beat of the same drummer, other factors come into play, particularly in this environment of historically low interest rates. Remember the investors who buy the pools of mortgages known as mortgage-backed securities? As interest rates decline and more homeowners refinance their mortgages at lower rates, these investors have a dilemma: They must reinvest in an unfavorable rate climate. Mortgage-backed securities lose some of the appeal to investors in such a circumstance, so investors tend to move money into Treasuries instead.
While this can perpetuate the ultimate decline in mortgage rates, investors use Treasuries to hedge their mortgage-backed holdings. They still hold long-term bonds, yet are less exposed to the early prepayment resulting from frenetic mortgage refinancing. Consequently, as rates decline on both Treasuries and mortgage-backed bonds, the spread between the two begins to widen. Look all the way back to July 3, when the yield on the 10-year Treasury note was 4.78 percent and 30-year fixed mortgage rates stood at 6.55 percent. The spread between the two, 177 basis points, would widen to 241 basis points by Oct. 9 as 10-year Treasury note yields plummeted to 3.61 percent and 30-year fixed mortgage rates declined to 6.02 percent.
The opposite scenario is now unfolding. As yields on Treasury securities have climbed along with the stock market over the past two weeks, the likelihood of continued refinancing poses a less onerous threat to investors in mortgage-backed securities. As a result, not all of the money moving out of Treasury notes lately has been headed back into stocks. As investors reverse their earlier positions when rates were dropping and move money from Treasuries back into mortgage-backed bonds, the spread between Treasury yields and mortgage rates has narrowed. The spread of 241 basis points in place as of Oct. 9 has contracted to 216 basis points since, with the 10-year Treasury note yield climbing to 4.24 percent and the 30-year fixed mortgage rate jumping to 6.40 percent.
As the economy continues to recover in the months to come, both Treasury yields and mortgage rates are poised to move higher. However, with the risk that refinancing poses to investors in mortgage-backed bonds decreasing, so too will the spread between Treasury yields and mortgage rates.
Greg McBride is a financial analyst for Bankrate.com.