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   ARTICLE   |   From Scotsman Guide Residential Edition   |   May 2018

The Bond Market as Crystal Ball

Understanding how it works can provide insight into rate changes

r_2018-05_lepre_spot.jpgYour phone rings. On the line is a client, who asks, “Where are rates going? Should we lock today?” In such a situation, as a mortgage originator, you can’t afford to react like a deer stunned by the headlights. 

No one expects you to be a Nobel Prize-winning economist, but originators should understand and be able to explain what causes movements in interest rates so they can provide borrowers with facts and intelligent estimates of what is likely to happen in the near future. The key to this is an understanding the bond market.

Although some express dismay that mortgage rates are slowly creeping toward 5 percent, keep in mind that in October 1981, the average 30-year fixed-rate mortgage was 18.63 percent and the 10-year Treasury yield was 15.84 percent. Apart from dealing with clients and providing a sense of perspective, having a sense of where rates are going in the next month or year can guide your marketing and business planning.

Government debt

Bonds are the main way that government agencies and corporations borrow money. When we talk about the “bond market,” we are restricting our discussion to the issues of the U.S. Treasury Department. The government spends a lot more money than it takes in. It makes up the difference by selling Treasury debt.

The Treasury borrows with maturities of four weeks; three and six months; and one, two, three, five, 10 and 30 years. The short-term debt instruments (one year or less maturity) are called “bills.” The two- through 10-year versions are called “notes.” The 30-year security is called a “bond.”

Bonds, notes and bills are sold at scheduled auctions. Before the auction, a coupon rate is set that reflects the yield, or total anticipated return on the Treasury debt security if held to maturity. When the auctions occur, there are two types of bids: competitive and noncompetitive. Most individual investors purchase Treasury securities by submitting a noncompetitive bid. By placing a noncompetitive bid, you are guaranteed an average yield and equivalent price determined by the competitive auction.

Competitive bidding is generally done by large financial institutions and brokers familiar with the securities market. As a competitive bidder, you must submit a sealed bid specifying to three decimal places the rate you are willing to accept. All noncompetitive bids will be accepted for that auction. The remaining balance of the offering is allocated among competitive bidders, beginning with the lowest yield (highest price) until the total amount needed is satisfied.

The bond market

Once the Treasury notes and bonds are issued and distributed, investors buy and sell these securities through a cash market called “the bond market.” One of the confusing things about the bond market is that the yield on the securities moves in the opposite direction to their price.

Take a 30-year bond at a coupon rate of 3.5 percent, for example. If it closed trading at a 110 19/32 bid, then for every $1,000 face value of bonds, someone was offering $1,106. Divide the 3.5 percent coupon rate by 1.106 and you get 3.16 percent.

That means the bond yield is 3.16 percent. When the price of a bond moves up, the yield moves down. In the example provided, the rate at which you receive payment on the bond is still the coupon rate of 3.5 percent, but because you paid a premium to get that 3.5 percent, the yield is actually 3.16 percent.

The Federal Reserve

The nation’s central bank, the Federal Reserve, is not allowed to purchase Treasury debt directly from the Treasury Department. It must do so on the open market. This enables the Fed to control money supply.

By purchasing Treasury debt on the open market, the Fed can increase money supply by crediting the account of the bond seller with money that did not exist previously. The prior holders of the Treasury debt purchased by the Fed now have cash.

Conversely, by selling Treasury debt on the open market, the Fed can decrease money supply. After a bond sale, the Fed receives the cash from the buyers, and that cash is no longer part of the nation’s money supply. It essentially disappears, thus decreasing money supply.

One sign of a coming recession is when the yield curve inverts—when the 30-year yield is less than the 10-year yield. 

Much is written about the role of the Fed regarding interest rates, but the important thing for mortgage originators to remember is that apart from home equity lines of credit, or HELOCs, that are based on the prime rate, the Fed has little direct control over mort-gage rates.

When the Federal Reserve is moving the federal funds rate up or down, the effect will be seen primarily on shorter-duration Treasurys (those with maturities less than five years). Practically speaking, the Fed controls the short end, but the market controls the long end with respect to rates, and it is the longer end that drives mortgage rates. Mortgage rates generally move in harmony with the 10-year Treasury yield.

Fed rate hikes are, essentially, preparation for a recession. The Fed may not believe that a recession is inevitable, but when it happens, it needs room to lower the federal funds rate. The Fed’s preparation for a potential recession may be construed as a forecast, but it is not that. It is more like buckling your seat belt. It is a precautionary measure.

The long game

 

Key Points

How to stay on top
of the bond market

Pay some attention throughout the day to the yield on the 10-year Treasury note. Monitor releases of macroeconomic data that can move markets, including the following:

  • The Consumer Price Index (inflation);
  • Gross domestic product (economic growth);
  • Retail sales;
  • The U.S. Bureau of Economic Analysis’ Personal Income and Outlays report; and
  • The U.S. Bureau of Labor Statistics’ Employment Situation report

Trades are based on interpreting fundamental data and what Federal Reserve monetary policy will do to inflation in the near future. Few people have a broad enough vision of the economy to make correct decisions about purchasing fixed-income securities, however.

In reality, the bond market is made on the margins. Well-informed people tend to buy and hold, while those less well-informed make shorter-term decisions based on reporting in the financial media. Often the effect of the latter is to cause overreaction.

To understand why inflation trends, and perceptions about inflation, are so important, think like someone with $100 million in liquid assets. If you’re wealthy, own your own home and have little debt, the goal of your investing strategy typically is to ensure you can buy as much stuff with that $100 million in the future as you can buy today.

You have only one enemy — inflation. Consequently, you invest in fixed-income securities: corporate bonds, Treasury debt, and mortgage-backed securities. If inflation is running at 2 percent, and your average return equals or exceeds that mark, your $100 million is not losing any future purchasing power. If inflation rises, however, you will want better returns to protect your money.

As a result, fixed-income securities like Treasurys are going to need to offer you higher yields in order to get your attention. Since mortgage rates move with the 10-year Treasury yield, one consequence of rising-inflation fear is that Treasury yields will rise to attract buyers, and that means mortgage rates rise as well.

The yield curve

One variable related to mortgage rates in 2018 that merits attention is the shape of the Treasury yield curve. The yield curve is a graph with debt-security duration on the horizontal axis and debt-security yield on the vertical axis. The yield curve is described as flattening when shorter-term yields move closer to long-term yields. As 2018 got underway, the yield curve was trending flat.

One sign of a coming recession is when the yield curve inverts — when the 30-year yield is less than the 10-year yield. The 30-year Treasury yield may fall as fear of a recession causes pension managers to move assets from equities to long-term Treasurys. More buying, or demand, at the long end increases prices for those debt securities but depresses yields.

Also, speculative investors who think a recession is coming may not invest their money in short-term securities because they are betting interest rates will decrease in the near future. Lower Treasury rates usually translate into higher demand and rising prices. So, speculative investors move toward long-term (30 year) bonds because those long-end plays will offer the most upside with respect to bond-price increases. Again, significantly more buying, or expanding demand, at the long end of the market eventually puts upward pressure on bond prices but reduces yields.

•  •  •

It is important to understand the mechanics of the bond market and stay on top of major economic-data releases that can affect the market. Then you can keep your risk-averse borrowers informed about these events so they have an opportunity to lock in their rates. This will go a long way to ensuring that your clients are well-served and happy.


 


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