What a Fed Rate Increase Could Mean For Mortgage Prices

Inside the 10-Year Treasury Bond Rate, Mortgage Rate Correlation

With a probable Fed rate increase looming, investors across many markets are crunching numbers and tossing out their analysis of what the increase will mean as 2017 hits and a new President takes office.

What typically happens when interest rates increase is there is also an increase in demand for short-term bonds. One of those most popular short-term bond is the 10-year Treasury bond, which is highly correlated to another major market that investors will be closely watching: mortgage rates.

In general, when bond yields go down, it creates an easier opportunity for those looking for mortgage loans.[1]

The tricky thing, however, about the mortgage market is that it's so interdependent on outside factors that those within the mortgage industry have little control over. This is the case when it comes to how the Fed interest rate increase impacts mortgage rates - specifically for its impact on 10-year Treasury bonds. 

But why does the change in Treasury bond rates have an impact on the mortgage market?

To start, it's about investors and where they want to stash their money. 

Fed Rates, Treasury Bonds and Mortgage Rates

As Federal Reserve Economic Data shows, the correlation between mortgage interest rates and Treasury bond rates is strong, but just how strong can better be understood by examining how investors view 10-year Treasury bonds versus mortgage-backed securities.[2]  The reason mortgage rates are correlated with is because, according to Investopedia, a 30-year mortgage rates actually has an average life of around seven years (Homeowners make payments, refinance their mortgages and then sell their homes).[3] That life cycle time explains why there is a correlation between mortgage rates and the 10-year Treasury bond.

While Treasury bonds have lower return, they are the most secure since they are backed by the federal government. Because mortgage-backed securities investors expect a higher return on their investment (riskier, longer-term investment), when 10-year Treasury Bonds rise, mortgage interest rates also rise. The riskier the investment, the higher return an investor would expect.

When Treasury rates increase, mortgage rates also increase in order to keep the rates of mortgage-backed securities competitive with Treasury bonds. When Treasury rates decline, the same happens to mortgage rates.

What this all boils down to how quickly investors are looking to turn around their investment. Longer-term investors typically look toward mortgage-backed securities, while an investor looking for a more secure, quicker payout may look toward a treasury bond. Because homeowners can default on their mortgage, by default they are a riskier bet than 10-year Treasury yields.

Because bond investors anticipate a good rate, but a lower return than mortgages, when Treasury note rates drop, mortgage rates drop. Similarly, when Treasury note rates increase, mortgage rates increase. This, of course, is all tied back to how much the Feds increase interest rates.

As interest rates increase, so does the demand for 10-year Treasury bonds. As demand for these short-term bonds goes up, it drives down the prices and the otherwise increase yields on these bonds.[4] While longer-term bonds are typically unaffected by Fed interest rate increases, short-term (2, 5 and 10-year Treasury bonds) are much more dependent on what action the Fed takes.

While longer-term bonds such as the 30-year Treasury Inflation Protected Securities are less impacted by the fluctuating Fed interest rate changes, mortgage rates (despite being longer-term) don't have the same stability.

The Treasury Bond, Mortgage Rate Connection

Mortgage interest rates are typically slightly higher than Treasury notes. Because Treasury notes are issued and backed by the Federal government, they are viewed as being more secure.

When interest rates rise on Treasury notes, it then increases interest rates on new mortgages. Higher mortgage rates, of course, means higher payments. This can have a chilling effect on the mortgage market and how many new and existing buyers are willing and ready to take on a new mortgage or refinance an existing one.

And so the domino effect begins.

Treasury bonds have an impact on mortgage interest rates for the same reason many financial investments do: they are competing to attract investors who want to find the best bang for their buck. That means, when interest rates on Treasury bonds fluctuate, the mortgage industry movers and shakers should have their ears perked for how it's going to impact fixed-rate mortgages.

Despite being low risk, they have a major impact on mortgage interest rates. Investors interested in mortgage-backed securities would expect to see higher interest rates (and higher returns) that typically would be found with Treasury bonds.

What that means for mortgage rates is, of course, still a bit unknown - but from many of the industry projections, a Fed rate increase will make its mark on the mortgage industry.



[1] http://www.cnbc.com/2016/07/06/how-the-10-year-yield-impacts-your-wallet.html

[2] http://finance.zacks.com/treasury-yields-affect-mortgage-interest-rates-2835.html

[3]http://www.investopedia.com/articles/pf/07/mortgage_rate.asp?ad=dirN&qo=serpSearchTopBox&qsrc=1&o=40186&lgl=baseline

[4] http://www.investopedia.com/articles/investing/121515/how-fed-rate-hike-will-affect-bond-markets.asp