Saturday, June 13, 2009

Why mortgage rates are rising

It’s pretty simple –

The Federal Government is selling more Treasury Securities to finance the economic recovery packages, the bank bailouts, the GM situation, the war, and the buying up of all these mortgages. In addition, as the debt grows, WE have to pay interest to all of these bond holders so even more debt is issued to cover the interest payments.

On the other side, buyers are scarce. China is less affluent and weary of US debt – there is even talk of downgrading US debt by Moody’s (England downgrade possible too). Last week Standard & Poor's raised worries that the United States could lose its "AAA" rating after it warned Britain was at risk for a downgrade. Both the British government and the U.S. government have had their central banks inject billions of dollars into their economies by buying bank assets.

The warning sent the dollar and Treasury prices tumbling last week, because a downgrade would increase borrowing costs and hurt the government's economic stimulus efforts. Moody's on Wednesday did not completely rule out a downgrade.

"Steven Hess, vice president and senior credit officer at Moody's, said that while the U.S. government's debt rating is stable, a reassessment of the economy and the government's debt could put 'negative pressure on the rating in the future.' He added that risks related to Social Security and Medicare could also affect the rating."
The Associated Press - ‎May 27, 2009‎

In order to sell more debt and attract skittish buyers, the prices of treasuries have fallen in recent auctions – price/yield is adverse in relationship so when the price drops (in order to attract buyers) it means the yields rise. As a result, the 10 year treasure yield has risen from 2.533% on March 18th to 3.695% on May 27th. That is over 100 Basis Points (1%) in yield.

The inverse relationship is easy to see with this simple illustration.

A bond is issued for $10,000 for five years with a 5% coupon or interest rate, paid every six months. Then interest rates rise to 6%.

If you want to sell this bond, who would buy it when it is paying 1% below market rates (5% vs. 6%)? You have to sweeten the deal so the buyer gets a market rate for the bond. You can’t change the interest rate on the bond. That’s fixed at 5%. You can, however change the price you will take for the bond.

The annual payment of $500 ($10,000 x 5%) must equal a 6% payment. Doing the math, you discover that the face value of the bond must be discounted to $8,333 so that the $500 fixed payment equals a 6% yield on the buyer’s investment ($8,333 x 6% = $500).

If interest rates went down instead of up, you could then sell your bond at a premium over face value because the fixed interest rate would be higher than the market rate.

Rates have not risen as much as the Treasury yield because the Federal Government is still buying mortgages out of the market, so the spreads over Treasuries are narrowing despite rising rates. At present we remain in a very abnormal market.

This is why federal debt is actually inflationary …
“Massive quantitative easing by the Fed is pouring trillions of U.S. dollars into the money supply, essentially conjured out of thin air. This is being done without transparency, the rationale being that frozen credit markets require a vast expansion of the money supply in an attempt to get the arteries of commerce flowing again. Similarly, the U.S. government is spending vast amounts of money it does not have, with the Treasury Department selling unprecedented levels of government debt in a frantic effort to fund the wildly expanding U.S. deficit. These two forces, quantitative easing and multi-trillion dollar deficits, are the core ingredients of an explosive fiscal cocktail that I believe will ultimately lead to hyperinflation.

What exactly is hyperinflation? Economists disagree on a common definition, so I will offer one myself. Double-digit inflation extending over a period of at least two years would arguably be a hyperinflationary period.
… What is most frightening about the policy moves being enacted by the Fed and Treasury is that their actions may not be a reckless gamble after all. They may have come to the conclusion that only hyperinflation will enable the United Sates to avoid national insolvency … If that is their prescription for the dire economic crisis confronting the U.S., then one must conclude that Ben Bernanke, Timothy Geithner and Larry Summers have learned nothing from history.”
Sheldon Filger
Founder of GlobalEconomicCrisis.com
Posted: May 25, 2009 12:36 PM
Huffingtonpost.com


David Stevens, President Obama’s choice to head the Federal Housing Administration (FHA) said in a recent email: “ …but if they weren’t doing what they are doing in the short run, mortgage rates would be in the 6.5% range.
…I do believe rates will rise ultimately here – and this trend will continue unless the international market becomes more supportive of US debt.”

Quick answer – buy now – don’t wait for lower rates.