RateWatch #320 - 4.00% 30-year Yield? Its Implications.
September 7, 2002
By Dick Lepre
In reading media accounts of what rates are going to do I have drawn the conclusion that something most dramatic is about to happen but no one is yet talking about it.
4.00% 30-year Yield? Its Implications.
Well, here we are, stuck with our rate forecast model which is telling us that something extremely dramatic is going to happen. The monthly Sto has turned bullish - higher prices, lower yields. It seems impossible that we can have lower Treasury yield when the 30-year is at about 5.00% and the 10-year at about 4.00% but that's what the model says.
The question for almost everyone reading this should be "what is going to happen to mortgage rates?" Our model forecasts the path of the 30-year future and, implicitly, the 30-year cash price of bonds. It is useful for forecasting mortgage rates only if: 1) the 10-year yield moves in step
with the 30-year yield and 2) MBS (Mortgage Backed Securities) move in step with the 10-year.
The model typically calls for a 15 point increase in the price of the future during the bull cycle. This implies that the 30-year Treasury bond will drop to something just over 4.0% within the next 15 months. What about the 10-year? The fact is that we do not know. We are in "uncharted
territory". Recall, that these periods where rates fall and fall and fall make the holders of MBS skeptical. Investors are assuming that the mortgages are going to live for a few years. When everything on the books seems to be getting paid off early they become unsure of what to do with the cash they have from the early payoffs and tend to "buy the long end" (the 30-year) and ignore the 10-year. This would lead to an "inverted" yield curve where the yield on the 30-year is less that the yield on the 10-year. These investors are seeking duration rather that return.
It is likely the case that, at first, lower 30-year Treasury bond yields will not drive mortgage rates down. But, if this period of economic stagnation lasts for a while we may see MBS return to vogue simply because they offer a better return than Treasuries. A scenario that seems possible to me is, then, something like this: Treasuries start to fall and mortgage rates fall "a little bit", convexity buying causes the 30-year yield to fall dramatically but the 10-year and MBS do not
move at all. Having sat for 3-4 months investors decide that MBS are a good investment because of the higher return and mortgage rates start to fall dramatically. Another period of "MBS angst" starts but from a lower level.
The picture that I see is that mortgage rates will fall dramatically when investors see MBS as an attractive alternative to Treasuries under 4% and to corporate debt which, for the most part, will be shunned due to risk.
A little game is working on the side here. Folks who are less interested than we are in seeing MBS become an attractive alternative drop terms like "the real estate bubble" implying that housing prices are inflated and MBS are in fact risky. Whereas real estate prices have
gone up "too much" in places where the supply/demand has been imbalanced and will inevitably correct this should not create anxiety about the underlying value of MBS. The beauty of MBS is that they spread the risk by combining properties from diverse geographic areas into a single
debt instrument and spread the risk of falling property values in one area over the entire country. These provide great safety when compared to S&L's and other lending institutions that concentrate the real estate loans in a single area. It is these entities, not the holders of MBS, that have to fear "the bubble".
Looking at "the big picture" the underlying implication of the bull market that we are about to have implies that we are in for very tough economic times. Recovery is not about to happen any time soon. Equity markets seem to have run into a quandary and its implications are vast. Everyone wants to invest in quality stocks but no one seems to know where to find them. Corporate
America and Wall Street have lost the confidence of investors. More economic damage has resulted from greed and stupidity than from the event of just one year ago.
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