Mortgage originators and the vast majority of homeowners benefit from low interest rates. In September of this year, mortgage rates fell to a historic low. At times in the past, these dips to record lows have been all too brief. Are things different now and will the low rates last for longer, perhaps until well into 2021?
Most everything that has happened to the U.S. and global economies in 2020 is a consequence of the COVID-19 pandemic and the associated uncertainty. Gross domestic product or GDP, the sum of all goods and services produced by a nation, dropped everywhere in the second quarter of this year, unemployment rose and the world plunged into a recession.
While domestic media concentrate on what is wrong with the U.S. economy, they tend to miss the point that things are worse elsewhere. According to the World Bank, an international financial institution that lends money to low- and middle-income countries, 92.9% of the world’s economies are contracting. The previous high was 83.8% during the Great Depression. A synchronous recession of this scale has never happened before. In 2020, global GDP per capita will experience its largest decline since 1945.
Concern about eurozone sovereign debt started in 2009 and has never really stopped. Greece, Portugal, Ireland, Spain and Cyprus were unable to repay or refinance their government debt, or bail out banks. By 2013, the effects were significant — unemployment rates in Greece and Spain reached 27%.
European Union (EU) nations have been adversely affected by COVID-19. Uncertainty about EU sovereign debt is not going away anytime soon. The EU has not made significant policy adjustments post-2009. It has, for example, yet to decide whether a serial defaulter such as Greece should remain a member.
Developing nations where one can find high yields on sovereign debt have substantial risk. This is reflected in their debt ratings. Four nations have defaulted on their debt, six are very close to default and dozens more are considered troubled. This is based on S&P debt ratings.
The U.S. is the nation that will benefit the most from this. While the U.S. has had a massive increase in both national debt and money supply, interest rates are at historic lows and the U.S. dollar remains strong when compared with the euro. The U.S. dollar is still the world’s most important currency.
Uncertainty created by COVID-19 will ensure that fixed-income investors seeking safe haven will go to either U.S. Treasury debt, or Fannie Mae or Freddie Mac paper. This likely means that mortgage rates will remain low through the end of 2021.
Investment demand
In estimating where rates will go, attention should be paid to the demand side — the individuals and entities that purchase fixed-income securities. Investors have several choices: equities, fixed-income securities and real estate.
A point of importance here is that those who are very wealthy are more inclined to not invest in things such as the equity market (mainly the stock market), which has risk. If you have enough to live on for the rest of your life, your only real enemy is inflation, which reduces the future purchasing power of your wealth. A safe thing to do is invest in fixed-income securities, which preserve that purchasing power. These are the people who purchase Treasury debt and mortgage-backed securities. Until the real economy recovers, money will move to safer fixed-income securities (government debt, mortgage-backed securities and high-rated corporate debt) as risk is perceived in equities. While fixed-income securities do not have high yields, what they do have is safety, which is especially true for U.S. Treasury debt and mortgage debt through the government-sponsored enterprises (GSEs).
To combat the economic fallout from COVID-19, the Federal Reserve has returned to quantitative-easing mode and is buying longer-term securities. Increasing the money supply in this way should have four effects in the following order. First, asset prices should increase, then the real economy (jobs and GDP) should grow. Inevitably, inflation happens and the Fed will then likely increase rates in order to abate inflation.
The U.S. will be stuck in the first phase until pandemic-related angst dissipates. The economy will grow, but it will happen slowly. Once businesses reopen, there will be a rise in jobs and GDP, but this will soon slow. It could take as long as 10 years to start seeing significant inflation.
Equity prices have been almost completely disconnected from inherent values and are being driven to impractical levels by momentum trading that is amplified by quantitative easing. When reality sets in, some experts believe equities are due for a significant correction. Money will move to the safety of fixed-income securities, forcing lower Treasury yields and keeping mortgage rates low.
Although some of the pandemic-fueled job losses will recover, the fact is that many businesses both large and small will be permanently closed. It may take years to regain jobs to the level of February 2020. As weak job and GDP data continue, investors likely will decide that the prices which equities were driven to by quantitative easing simply were not supported by earnings and that potential earnings were overestimated.
The economy is akin to an overstocked store with too few customers. Stores react by lowering prices. This downward pressure on inflation will drive Treasury and mortgage rates lower.
Dual mandate
The Federal Reserve has the dual mandate of keeping the rates of inflation and unemployment low. Before COVID-19, both had been remarkably low. Inflation, as measured by the consumer price index (CPI) — the average change over time in the prices paid by urban consumers — has not been above 3% since December 2011.
The CPI was at 2.3% in February 2020, the last month prior to the pandemic. In the same month, the unemployment rate was 3.5%, matching a 50-year low set for a few months in 2019. Fourth-quarter 2019 GDP grew annually by 2.1%. It is fortunate that the pandemic struck at a time when the U.S. economy was extremely strong.
In late August 2020, the Fed announced that if both goals of the dual mandate could not be simultaneously achieved, it would give priority to achieving low unemployment versus keeping inflation below 2%. It did this in what was seen as an awkward manner by stating that it would use average inflation as measured by the CPI over a longer-term period rather than the most current CPI.
Although this policy change has been severely questioned by those who write about the Fed and monetary policy, it is likely a sensible choice. The U.S. needs to have the significantly large number of people who are not working return to the labor force, get paid and be able to take care of themselves. Inflation, while not a positive, is less important than getting people employed.
It also is worth noting that inflation has two sides. One is the cost of goods and services, such as food, energy and housing. These can easily fluctuate up and down. A more permanent form of inflation is wage inflation, which rarely moves down after moving up. It is unlikely at present that encouraging employment is going to cause significant wage inflation. As long as many people are applying for a job opening, employers do not have to raise wages to fill jobs.
Reemployment will likely happen over a period of years rather than months. This will involve inflation and keep mortgage rates down. The likely absence of wage inflation as the unemployment rate declines will tame price inflation.
The present state of the GDP, consumer prices and unemployment are caused by an event which has not happened since the 1918 flu pandemic. A weakened economy will result in very low inflation, which will keep interest rates low. The economy is akin to an overstocked store with too few customers. Stores react by lowering prices. This downward pressure on inflation will drive Treasury and mortgage rates lower.
All of these factors will play a role in keeping interest rates low at least through next year. And that’s good for mortgage originators as well as borrowers. ●
