Why are Mortgage Rates so Low?
Chuck Ponzi April 25th, 2006
With the rising cost of gasoline, you may be mad at me for even suggesting that some kind of costs rise. However, historically, you will find that Mortgage rates are much lower than they typically are considering the cost of money.
If we take the mortgage rates over the past 15+ years and map them agains the Fed Funds Rates, you will see that there is a loose correlation.
While the 30 year mortgage rates are represented by the red line and the Fed Funds Rate is represented by the blue line, I took the liberty of adding some trendlines to show the general movement of the 2 rates.
Based on this simple analysis, there are a few things we can see from the information being represented graphically.
1. The rates have tended to move in similar directions for most of the period, albeit in smaller swings for the mortgage rates.
2. In general, the path of rates has been down. Although multiple inflection points are observed, the general trend is down.
3. The periods of smallest disparity happend twice (1991 and 2001) at the outset of recessions (this is also related to an inverted yield curve)
4. After these periods of stress, rates were quickly dropped.
Based on the historical average, the spread between the 2 rates have averaged 3.33% over time. Given the current FFR of 4.75, we should be seeing mortgage rates about 8%, but we are hovering just above 6%. This is the “conundrum” that Greenspan was worried about and the same one that Bernanke dismisses with his “global savings glut” theory.
Perhaps I can provoke a couple of thoughts from my readers.
1. Why are rates going down over time?
2. Is there a savings glut?
3. Why are risk premiums (spread) so small?
4. Are we about the enter a recession like the other small spreads indicated?
To the last point, if we enter a recession, is there any chance that housing can be saved through inflation? Does this mean 70’s style stagflation, or even worse, Japanese style deflation with ZIRP?
If anyone can provide a coherent way that housing can survive in the next 2 years, please tell us now!
At this point, I think we are out of options from a monetary perspective.
1. We already have inflation. Dropping rates will make it much, much worse.
2. Economic growth is slowing despite the mad dash of construction.
3. The credit market is precariously spread and rates could make a mad dash upward if international investors get spooked and run for the exits. The only way to keep the Dollar from meltdown at this point will be to raise rates even more.
4. Housing speculators will be crushed by negative amortization and high interest rates in this event(which arguably should have already happened by now).
5. The sitting inventory will cause personal financial distress and combined with the mad dash of rates could generate a general credit system event.
Either way, we will be seeing a much more favorable buying environment for housing in 3 or more years due to the general stress and turning of investor sentiment. 
One of the main reasons Interest Rates are lower than they historically should be is due to vast improvements in the efficiencies of Lenders. Risk is better valuated, technoligy has more than halfed the labor involved, and the number of lenders compeeting for borrowers has balooned even more than housing prices.
All of this equates to lean mean mortgage machines.
Todd,
True, even so, do you think the flat or inverted yield curve is also a product of efficiencies? Not meant to be antagonistic at all; I don’t think I have heard any thoughts from someone in the mortgage business about risk premiums.
I guess I could see maybe a .5% or .75% at most being shaved off the rates over the past 25 years or so. Capital markets have gotten considerably better mostly because of the global glut of liquidity, however in the light of all of this together, I don’t see any substantial change from just 5 or 10 years ago; the amount of lending is unprecedented and I still feel the capital markets need a bust to tell them where the new limits have been set. Either way, the spread between 5 year, 15 year, and 30 year rates are historically unreal.
Again, I think you’re at least partially right, but I don’t believe that it explains the flat yield curve. Basically, the Fed has added 3% and the capital markets subtracted .5%. That spells disaster for MBS holders in my book.
I meant to say it added the 3% in the last 2.5 years, so can efficiency really account for that much in recent movement?
I think you have to look at the amount of people that were burned from the 2001 recession and also look at the amount of money that foreign investors have dropped into the dollar and other treasuries investments. The 30 yr. held strong for almost two years now as the rates have been rising consistently. At some point the demand for conservative investments will weaken and the rate will catch up. The long term yields have the lag in them. I think we are inevitably going to hit 8% by 2007.
China financing its trade deficit with the US by buying 10 year treasuries. If the dollar starts to drop (oh, what was that sound?!) they might want to reduce their exposure, however, and reduce their purchases of the 10 years, which are the biggest factor in mortgage rates.
The world is awash in money. Maybe not you, or me, or the friends we hang with, but the world at large is swimming in money.
Yes, there is a world wide savings glut.
Rates are low and risk premiums are thin simply because there are so many dollars chasing so little opportunity.
Yes, a recession in ‘07 is possible IF corporate spending doesn’t compensate for the inevitable drop-off in consumer spending. But that is a big if. Corporate borrowing has been extremely low because they are flush with cash, and the probabilty of ramped up spending in ‘07 is high.
Here is something to consider.
One of the main reasons interest rates are lower is due to the Carry Trade. The Carry Trade took easy money from Europe and Japan and it poured into US Treasuries holding down interest rates and from there to mortgage backed securities then to REITS and other investments. That is what fueled the last RE boom. Now that Japan has greatly reduced its reserves and has announced it is marching towards adding cost to its currency combined with Europe tightening, that dynamic has changed. This is the first time in 20 years all three central banks are tightening at the same time. It’s interesting this global glut of liquidity is now finding its way out of US Treasuries and into commodities. That will find its way into the CPI numbers and the FED will have to tighten more than anticipated. So you have reduced demand in the long bond because of structural changes of the carry trade, and rising commodity prices which are inflationary which will force the FED to continue to tighten on the short end. All of this while RE has just come off its biggest run-up in this country’s history and affordabilty is in the single digits in bubble markets. It kind of reminds of that movie “The Perfect Storm”
Yes, Both Anonymouses,
When I first heard about the global savings glut, I was very skeptical myself… but after reading some scholarly articles on the subject, I admit that the amount of savings is indeed much higher than the world needs.
Of course, it is all relative. Those in the undeveloped world are still crying for capital, but we are awash in a sea of liquidity that has for some reason stuck in developed economies fueling a world wide housing bubble (crummy homes in Costa Rica are going for 500K+ for goodness sakes!) This cannot end well for the owners of low-yield bonds. They may find the losses from such investments are far worse than they could ever imagine. So much for FNM or anyone else backing those if they are bankrupt.
I see a credit event on the horizon. I cannot imagine it happening any other way. Risk premiums are just out of whack.
“I see a credit event on the horizon”
Yep!
IF anything is going to cause a so-called reversion to the mean in housing, it will come from the credit markets. Again, that is a big if.
I agree. The reckoning to credit markets is well under way. Beware and hold on.
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[…] easing campaign by the Federal Reserve Bank. To that point, just over 2 years ago, I wrote about interest rates and what that portended: 1. Why are rates going down over time? 2. Is there a savings glut? 3. Why are risk premiums […]