Interest Rate Spreads And Why The 10 Year Treasury Is Not The Best Indicator Of Mortgage Rates

One of the topics that comes up on a daily basis with my clients is the relationship between mortgage rates and the headline-grabbing interest rate reference points like the 10 Year TreasuryNote, or the Federal Funds Rate.

A very common misconception is that mortgage rates are based on the 10 Year Treasury Note. I am not exactly sure what the logic there is, but I have heard people say that the average 30 year mortgage lasts only10 years. Seems like a pretty loosey-goosey way for a bank to call out a price for lending their money out on a 30 year term. Do mortgage rates correlate to the 10 Year Treasury at all? Over time, mortgage rates and the 10 Year Treasury do trend in the same direction, but on a day by day basis, they often go in different directions, or at least at a different pace. There are separate specific implications for each, and they react to a different set of data points in different ways - at times, the differences can be significant.

The other question I get rather frequently is how the Federal Reserve will impact rates with their recent string of cuts to the Fed Funds rate. People continuously expect that its best to wait until after the cut to take advantage of lower rates. Again, not the correlation you are looking for. The Fed has cut 7 times in the recent cycle, and on the first 6, mortgage rates spiked in response. On the last one, rates went down a little. Do mortgage rates react to the Federal Reserve actions? Absolutely, but its the greater economic context that matters at the time, and dictates the type of reaction.

So what's the best metric for determining mortgage rates? MBS, or mortgage-backed securities, aka mortgage bonds. Read a definition of these here. When mortgage bonds trade at higher prices, the associated interest rates drop. This tells lenders for new mortgage issues what the current value and rate of return is on long-term bond money, and helps them set their rates.

Each of the first 6 cuts this time around have brought on a perceived increase to the threat of inflation. Long term fixed-income securities, like bonds, Treasury Notes, etc, HATE inflation. If you were a bank, and committed to lend 100 dollars to somebody for 30 years, and then inflation doubled, your 100 dollars would be worth far less than you had expected it would be when you loaned it out. So you would loan your next 100 dollars at a higher interest rate to compensate. Accordingly, rates on mortgages jumped at each time.

Then on the most recent cut, the Federal Reserve hinted at the idea that this would end the cycle. It gave the bond market confidence that no further inflation pressure would be invited, and the bonds rallied on the news. Rates went lower.

The bottom line when it comes to trying to predict mortgage rates, is that you need to know where MBS are trading, and what the climate is for them amidst the constant inflow of economic data points. They react very strongly to things like the Unemployment data, GDP, CPI, PCE, PPI, Home Starts and Sales, and a bunch of other metrics. Depending on the mood, different indicators have different impacts. If inflation is a hot button, the inflation barometers like the CPI and PCE will have heavy influence. If we are looking for indicators of recession, MBS will be sensitive to GDP, Consumer Confidence, Retail Sales, etc.

The Cleveland Federal Reserve has an article out discussing the increasing spread between Treasury and mortgage rates. With the current credit crisis, money has rushed into bonds as usual. But mortgage bonds have been relatively less appealing, as the whole mortgage marketplace is at the epicenter of the crisis. Last time we had a recession, money flooded into all bonds, Treasury and especially MBS because the housing economy was strong, and MBS values were thus very secure. This is why we are seeing a lack of correlated movement between these two instruments.

If you are entrusting a mortgage professional with the management of your debt, you need to align with one who understands interest rates. They need to specifically understand the market for mortgage-backed securities, and the economics behind the current credit and liquidity crisis. If the person you are speaking with tells you that mortgage rates are based on the 10 Year Treasury, or especially if they call the 10 Year Treasury Note a Treasury Bond, there's a risk they are going to mishandle your business. And if they say they 'can't see into the crystal ball', its likely a sign that they don't have a clue what upcoming events might be influencing rates.