Questions considered include: Do declining bond prices cause rising interest rates? Why are mortgage rates today much lower than in the early 1980s? Why are rates so much higher in some countries than
Questions About Mortgage Interest Rates
4 October 2001, Revised 11 November 2004, February 22, 2005, November 24, 2006, February 22, 2007, August 27, 2011
Do Declining Bond Prices Cause Interest Rates to Rise?
No, declining bond prices are higher interest rates.
Suppose on Monday the US Government sells a one-year note at 5%, meaning that an investor purchasing a bond today for $1,000,000 would receive $1,050,000 at the end of the year. Lets suppose further that moments after the sale of these notes is completed, the Government announces that because it's deficit is much larger than expected, it will need to raise much more money than it had previously thought. When it enters the market on Tuesday, therefore, it must pay 10% on the otherwise identical note.
Since investors can now earn 10% on the Tuesday note, the price of the Monday note must fall enough so that investors earn 10% on that one as well. This forces the price down to $954,545.
The interest rate on the Monday note when it was sold was 1,050,000 divided by 1,000,000, minus 1, or .05. The interest rate on Tuesday was 1,050,000 divided by 954,545, minus 1, or .10. The decline in price and rise in rate are the same thing.
Why Are Mortgage Interest Rates Today Much Lower Than In the Early 1980s?
The major reason is the taming of inflation.
Economists distinguish between the “nominal” rate of interest and the “real” rate. The nominal rate is the one that is quoted. The real rate is the nominal rate adjusted for inflation. Lenders are concerned primarily with the real rate.
Suppose a lender is willing to lend $100 for a year if he gets back $106. That’s a nominal rate of 6%, and if there is no inflation over the year, the real rate is also 6%. This means that the lender who could buy 100 widgets at the beginning of the year at $1 a widget, could buy 106 at the end.
But suppose lenders expect the price of widgets to rise by 5% over the year. Then at 6% the $106 the lender will have at year-end would buy barely 101 widgets. To maintain a real rate of 6%, the lender must raise the nominal rate by 5% to offset the declining value of principal, and by .3% to offset the declining value of the interest. The adjusted nominal rate is thus 11.3%. With $111.30 at the end of the year, the lender can
buy 106 widgets at $1.05 a widget.
In Surinam, Mortgage Interest Rates Are 36% or More. Why Are Rates so Much Higher in Some Countries Than In Others?
I have already discussed the most important reason. Rates were as high as they were in Surinam because the inflation rate there was high. Countries with high inflation rates have high interest rates.
A second factor that affects mortgage rate differences between countries is the efficiency of the housing finance system. In most respects, the US system is more efficient than those in most other countries. As a result, mortgage rates to prime borrowers in the US are only 1-1.5% above long-term Government bond yields. In many other countries, the spread is twice as large or more.
The Fed Recently Dropped Rates by 1/2%, But Nothing Happened to Mortgage Interest Rates. Doesn’t the Fed Control Mortgage Rates?
Your sense that nothing happened is based on the stability of mortgage rates after the Fed action. But since the market anticipated this action, whatever impact it had on mortgage rates occurred before the action.
Nonetheless, the impact could have been small because the Fed does not control mortgage rates. The Fed controls the Federal Funds rate at which banks lend to each other overnight, and the discount rate at which Federal Reserve Banks lend to commercial banks for very short periods.
While short-term rates and long-term rates are related, the relationship is loose. It is not unusual that a large change in short-term rates is accompanied by a much smaller change in long-term rates. Indeed, because short-term rates are much more volatile than long-term rates, this is more the rule than the exception.
What Interest Rates Predict the Direction Mortgage Interest Rates Will Take?
Before the development of secondary mortgage markets, there was an answer to this question. Changes in mortgage rates lagged changes in corporate bond yields by anywhere from 2 to 8 months.
Today, however, the mortgage market is so thoroughly integrated into the broader capital market that there are no leading indicators of mortgage rates. Mortgage rates and bond yields change together.
A large proportion of all mortgages are placed in pools against which mortgage-backed securities (MBSs) are issued. MBSs trade actively in the market and are considered close substitutes for bonds. Any change in bond yields, therefore, is transmitted instantly to the MBS market.
Mortgage loan originators, in turn, base their rates primarily on yields in the MBS market. Originators usually post their rates at about 11am EST, after they see the opening yields on MBSs that morning.Source: www.mtgprofessor.com