Interesting Interest Rates – No Place But Up From Here

Since mid-2008 the U.S. Federal Reserve has flooded liquidity into the markets, at which time I gave up trying to forecast interest rates. It was akin to a gambler with $100 in their pocket trying to break the bank in Las Vegas, so-to-speak.

Until recently, however, there was but one simple answer—rates were going down.  The following graph depicts the weekly 30-year residential mortgage rate as reported by Freddie Mac commencing January 1, 2000.  The area circled in red changes the statement from “rates are declining” to the premise now that “rates are rising.”

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Today, 30-year residential mortgage rates are now at the highest level since April 12, 2012, and have risen significantly for five consecutive weeks, as illustrated by the following graph. These are the same data as in the prior graph, but just for the time period since January 1, 2012.  This new trend is being driven by an awakening economy, that given the current level of M1 Money Supply (cash, demand deposits and checking accounts—which is at an all-time high with the potential when returning to normal velocity levels to grow the economy 36 percent), can create a wildfire level of economic growth as consumers and business America become more confident and spend this cash.

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We know that, in efficient markets, there will be a link among various duration and risk levels of securities.  When tracking 30-year residential rates, what is the best leading indicator?  To answer that, the Pearson Product Moment Correlation Coefficient was calculated with the results detailed in the following table.   Using data spanning the period from January 1980 through April 2013, the greatest correlation was measured when comparing the 10-year constant maturity U.S. Treasury bonds to 30-year fixed-rate mortgage interest rates.  The same answer held when comparing the U.S. 30-year residential mortgage rate in the pre-housing bust market from January 1980 through December 2007.  But when the housing-bust period from January 2009 through April 2013 was compared, the strongest relationship is now the 5-year constant-maturity Treasury.

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This next graph shows the relationship between the 10-year Treasury, 5-Year Treasury and 30-year residential rates. The first thing that we need to appreciate from this graph is how extremely affordable residential interest rates are today, even after commencing what I believe is a longer-term upwards trend.

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This next chart shows the interest rate spread between 5- and 10-year Treasures and 30-year fixed-rate residential mortgage rates.  Since these vary randomly month-to-month, a 12-month moving average is used to smooth the data and provide more distinct trend lines.

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So what has caused the recent massive yield difference between 5 and 10-year Treasuries and 30-year residential rates?  I believe it has been Quantitative Easing (QM).  QM is when the Federal Reserve (Fed) essentially injects massive amounts of liquidity into the banking system in hopes of driving short-term interest rates lower causing increased borrowing by businesses and individuals to stimulate the economy (see a previous blog at http://blog.stewart.com/stewart/2012/09/26/qe3-and-we-are-not-talking-about-an-ocean-going-ship/ ).

 

The Fed has been adding $85 billion of essentially newly-minted money each month by buying short-term bonds which expands the money supply and drives down short-term interest rates.  In so doing, they have basically been “Watering down” the value of the U.S. dollar, which in the long run can be inflationary in nature.  When consumers and business America commence spending this money, to moderate inflation, the Fed will raise the Fed funds rate, increase reserve requirements by lenders, and issue new longer-term Treasury notes and bonds, and in so doing, drive interest rates higher.

 

The biggest impact of QM has been on shorter-term Treasuries, and in this analysis, that means the 5-year Treasury note.  So expect that to rise.  Now recall as stated early on in this blog, that since the housing bust in 2008, 30-year loan rates have been best correlated with the 5-year Treasury note.  And the impact?  Yep—rising 30-year residential interest rates.

 

The next question is what will be the impact of rising interest rates on U.S. housing markets?  In most markets, as rents continue to escalate, prospective homebuyers face either the choice of higher rents or greater mortgage payments.  Either way, they will pay more.  As long as job and income growth continues, there really is not much of a problem provided interest rate rises correspond with job growth percentages.  The downside will be in those markets where recent record-low rates have spurred significant home price increases (think California).  Buyers are bidding up a very limited inventory since monthly payments are so low given minimal long-term rates.  As rates rise, these markets are the most at risk to falling demand and potentially reduced demand and stagnating prices.   But if job and income growth match rising rates, there is no problem.

Rates are going up.  But they remain highly affordable.  And if job and income growth match interest rates increases, there is no big deal ahead.  I do encourage long-term fixed-rate loans for almost every circumstance, as no one truly knows how long they will live in or own a specific property.

Things are looking up—including interest rates.

Ted

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