Monday, June 22, 2009

Rate Outlook

Last week's drop in mortgage rates was a welcome relief, and you would think that more relief should be forthcoming. After all, inflation appears to be a dead issue, given recent data on producer and consumer prices. Inflation and interest rates are highly correlated: When one falls, the other usually falls in tandem.

But there is more to the story than inflation. All interest rates are determined relative to risk-free market interest rates, with short-term Treasury bills serving as a proxy. But most interest rates are not risk-free. Mortgages rates are certainly not risk-free, which is why they are higher than Treasury bill rates. What's more, mortgage rates are heavily influenced by rates on mortgage-backed securities (MBS). MBS rates, in turn, are heavily influenced by yields on Treasury bills, notes, and bonds.

And there is the rub. Treasury securities prices tumbled last week after the government announced $104 billion in debt auctions. As rates on Treasury securities increase to attract buyers, there is a crowding out effect, because Treasuries compete with other debt instruments for buyers. If Treasury securities must raise their yields to attract buyers (which happened last week), then so do most other debt securities; hence, a possible increase in mortgage rates.

We can't be sure what impact this crowding effect will have. Rates could go higher, but they could go lower too, particularly if the Federal Reserve continues to implement its $300-billion program to create demand and keep a lid on rising rates. But why chance it? Thirty-year fixed-rate loans averaging between 5.5% to 5.75% are still a very good deal, as are the deals found on most existing and new homes on the market.

Eric P. Egeland
Broker Associate

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