What Is the Future of Interest Rates?

The Mortgage Corner

The deficit is moving to the back burner with Donald Trump and congressional Republicans in charge of Washington, and that is causing interest rates to rise quickly. Republicans leaders on Capitol Hill are now papering over divisions with Trump and deficit hawks are sounding the alarm, reports Politico.

“There is now a real risk that we will see an onslaught of deficit-financed goodies — tax cuts, infrastructure spending, more on defense — all in the name of stimulus, but which in reality will massively balloon the debt,” said Maya MacGuineas, president of the Committee for a Responsible Federal Budget.

So we should look at Treasury Security yields, such as for the 10-year Treasury Bond to understand the future trajectory of interest rates. And bond yields are rising with the 10-year bond yield now at 2.25 percent, up from 1.71 percent just one week ago. But this is still far below the 4-6 percent yields in mid-2000, when 4 percent inflation and 6 percent fixed rates prevailed.

Calculated Risk’s Bill McBride predicts higher mortgage rates ahead, though still at historic lows. “With the ten year yield rising to 2.25 percent today, and based on an historical relationship, 30-year rates should currently be around 4.1 percent,” he said.

The 30-year conforming mortgage rate is already approaching that rate, with 30-year fixed rates @3.625 percent for a 1 pt. origination fee (3.875 percent for 0 pts.), and the Hi-Balance conforming fixed rate now 3.875 percent for 1 pt. origination, up ¼ percent just from last Friday.

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Graph: St. Louis Fed

What is happening to make the 10-year Treasury rate rise so quickly, after staying below 2 percent for most of this year? It’s partly because we are at full employment while incomes are rising, and rising wages are two-thirds of product costs. Hence companies will raise their prices in response to such rising costs.

But that alone can’t account for such a quick rise. It also has to be because investors and the financial markets are anticipating that President-elect Trump will be able to push through a massive, possibly $1 trillion plus infrastructure rebuilding, which was a campaign promise. And he also wants to cut taxes.

This happened in 2001, when GW Bush pushed through massive spending to pay for his Wars on Terror, while also cutting taxes. His budget deficit therefore increased, and bond markets in particular don’t like large deficits, as it means too many bonds are in circulation to pay for those deficits, which reduces their price—and bond yields rise in inverse proportion to falling bond prices.

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Graph: Calculated Risk

There’s also the anticipation that this will cause future inflation with so much money flooding into the economy at once. The above Calculated Risk graph shows the historical relationship between the 10-year bond yield and 30-year fixed mortgage rates.

We are therefore lucky at this late stage of a recovery to still see 4 percent fixed mortgage rates. One can see when the 10-year yield returns to a more normal 3.5 to 4 percent yield, fixed mortgage rates could almost double.

That’s why the 30-year fixed rate mortgage rose as high as 6.48 percent in 2006 at the top of the housing bubble. Will this hurt first-time homebuyers in particular? Not if inflation and housing prices don’t rise as fast, and construction can keep up with the rising demand for new homes.

Harlan Green © 2016

Follow Harlan Green on Twitter: https://twitter.com/HarlanGreen

About populareconomicsblog

Harlan Green is editor/publisher of PopularEconomics.com, and content provider of 3 weekly columns to various blogs--Popular Economics Weekly, The Huffington Post, and PeaceCorpsWorldwide.org.
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