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   ARTICLE   |   From Scotsman Guide Residential Edition   |   May 2017

Finding Comfort in History

Rising interest rates won’t wipe out the mortgage industry in 2017

Finding Comfort in History


Reasons not to be concerned by Federal Reserve actions

  • During money-tightening periods, increases in bond yields generally are less than half of the increase in the federal funds rate.
  • Historically, 30-year mortgage rates rise and fall with 10-year bond rates, not short-term interest rates.
  • Since the Great Recession, the Federal Reserve has overestimated growth in U.S. gross domestic product, so planned increases based on inflation fears may not happen.
  • Quantitative Easing (QE) doesn’t appear to have any meaningful impact on Treasury bond yields, so ending QE should have little effect on long-term mortgage rates.

Many mortgage originators and bankers have been worried about 2017 and how expected increases in the federal funds rate will affect business. Starting in late 2015, the Federal Reserve embarked on its fourth tightening regime since 1990. In addition, after the 2016 election, long-term rates increased further because investors expect some sort of fiscal stimulus.

Luckily for mortgage originators worried about the effects of rising rates, the historical behavior of long-term interest rates can help put the current behavior of the bond market into context. By looking back at recent interest-rate history, we can alleviate fears that originators might have about the future.

Interest rates are the lifeblood of mortgage originators, and increases in interest rates are generally associated with tough times for the sector. That said, mortgage rates are more closely linked to long-term rates, such as the 10-year bond rate, than the federal funds rate — which the Federal Reserve, or Fed, uses to steer the market. In fact, historically, 30-year fixed-rate mortgages have remained right around 167 basis points higher than the 10-year rate.

The good news for mortgage originators is that the yield curve usually flattens out during a tightening cycle, which means long-term rates rise much less than the federal funds rate when the Federal Reserve begins tightening credit. During the last three tightening cycles, the 10-year bond yield generally increased by less than half of the increase in the federal funds rate over the same period of time.

In the 1994 tightening cycle, Alan Greenspan raised the federal funds rate 300 basis points over the course of 14 months. This period was famous for the Orange County bankruptcy and the collapse of several prominent mortgage-arbitrage hedge funds. During this cycle, the 10-year bond yield increased about 160 basis points, or about 52 basis points for each percentage point increase in the funds rate.

During the 1999 tightening cycle, the Fed raised the funds rate 175 basis points, while the 10-year bond yield only increased 70 basis points. This tightening cycle was famous for pricking the stock market bubble of the late 1990s. Finally, the 2004 cycle saw a 425 basis-point increase in the funds rate, with only a 50 basis-point net increase in the 10-year bond yield. This cycle was the one that burst the residential real estate bubble.

All three times the Federal Reserve tightened credit over the past 20 years, the yield curve flattened. If you average out the percentage increases in the 10-year bond yield versus the increases in the federal funds rate, you find that bond yields rise about 34 basis points for each percentage point increase in the federal funds rate.

Current cycle

If we examine this flattening in the context of the current cycle, we see the federal funds rate has increased 50 basis points over the 13 months ending December 2016, from 25 basis points to 75 basis points. The yield on the 10-year bond has risen from 2.2 percent to 2.45 percent, or 25 basis points as of this past December.

Based on prior cycles, the 10-year bond should be trading closer to 2.3 percent. In fact, if the Fed hikes the funds rate an additional 75 basis points in 2017, as the Federal Open Market Committee predicted in December 2016, that would imply the 10-year yield would reach 2.65 percent by the end of 2017. If they hike the fund rate by 50 basis points instead, that implies a 10-year rate of about 2.55 percent.

And yet, as of early 2017, 10-year bonds are already trading in the 2.5 percent to 2.6 percent range, which means the market is fully discounting those Fed rates hikes as if they had already happened. In other words, the 10-year may be a little ahead of itself and could take a breather while the funds rate catches up. While not impossible, it is hard to see how another 75 basis points in the federal funds rate would translate into a rate bump of 50 to 75 basis points on the 10-year bond.

The stock and bond markets have gone in different directions since the election, exhibiting the classic “risk-off” behavior where investors sell safer assets like Treasury bonds and buy riskier assets like stocks. The Fed baked the possibility of fiscal stimulus measures into its economic projections for 2017, which influenced their forecast for the path of the funds rate. If we do not see the expected fiscal stimulus out of Washington, the forecast of three rate hikes is probably too high, even though the first of those hikes, at 25 basis points, occurred this past March.

Overblown forecasts

It also is important to note that the Fed has been consistently high in its forecasts for gross domestic product (GDP) growth. A Fed forecast for GDP growth made in 2014 predicted that 2016 GDP growth would average between 2.5 percent and 3 percent. That estimate was revised downward at subsequent meetings. The final forecast made this past December still had GDP growth for 2016 up close to 2 percent, while the actual growth came in closer to 1.5 percent.

The yield curve usually flattens out during a tightening cycle, which means long-term rates rise much less than the federal funds rate.

This has been a pattern since the Great Recession: The expected economic rebound has been weaker than normal. That could be the result of too much emphasis on recent history. It is important to keep in mind that this recession is fundamentally different from recessions the country has experienced since World War II. Those recessions were driven by monetary tightening in order to quell inflationary pressures. The increase in interest rates would depress the business and consumer sectors, which caused inventories to build and companies to lay off employees. Those recessions typically ended once the inventory was worked off and pent-up demand had a chance to build.

Recoveries after asset bubbles are fundamentally different, in that the problem isn’t a surplus of inventory, but a surplus of bad debt from the bubble years. This takes a much longer time to work off, because it is a function of the legal system and time. In addition, the concomitant loss of confidence becomes a “wall of worry” that takes time to break down.

This confidence problem is evident in the lack of housing starts, despite a shortage of housing. Builders are reluctant to buy land and smaller bankers are reluctant to lend to developers. This translates into mediocre economic growth and “lower for longer” interest rates.

We have seen this before — in Japan. The lesson from Japan is that interest rates don’t rise as quickly as central bankers might prefer. The Bank of Japan has tried to get off the zero mark twice since the bubble burst, and both times had to reverse course. In fact, short-term rates are still at record lows. Although the circumstances between the U.S. and Japan are different, the characteristics of post-bubble recoveries remain the same.

Quantitative easing

One final factor to consider is the Fed’s status on quantitative easing (QE) and the state of their balance sheet. The Fed has increased the size of its balance sheet from about $800 billion to $4.5 trillion by purchasing Treasury bonds and mortgage-backed securities (MBS).

Since the end of QE, the Fed has maintained its assets at the $4.5 trillion level by re-investing maturing proceeds back into the market. In 2016, the Fed purchased over $380 billion in MBS as total mortgage originations came close to $2 trillion.

Recently, however, there has been discussion by Fed officials about shrinking its balance sheet by allowing maturing securities to run off. As the Fed moves in that direction, a major source of demand for mortgage-backed securities will disappear, which intuitively should have a negative impact on mortgage pricing.

If you look closely at the data, however, you see that there doesn’t appear to be a meaningful change in the spread between Treasury yields and mortgage rates during QE years. Prior to the Great Recession, the spread between the 30-year fixed-rate mortgage and the 10-year bond was pretty constant at around 1.66 percent, and that didn’t change significantly when the Fed was buying up mortgage-backed securities. A full exit from QE should not have a major effect on mortgage rates either.

•  •  •

Overall, it is hard to predict what will happen to interest rates in 2017; however, fears that a 75 basis-point hike in the federal funds rate will translate into a 75 basis-point increase in 30-year mortgage rates are probably overblown. If history is any guide, the yield curve will flatten as the Fed announces rate hikes, which means long-term rates will rise slower than short term rates.

In many respects, the 10-year bond is priced as if those hikes have already happened. Given the Fed’s habit of overestimating future GDP growth, and political uncertainty in Washington, we may not even see a 75 basis-point hike in the funds rate this year. The end of the Fed’s reinvestment strategy should not affect mortgage spreads materially, either, so 2017 might not be the disaster in the making that many in the industry fear. 


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