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Interest rates are the lifeblood of mortgage originators, and increases in
interest rates are generally associated with tough times for the sector. That
said, mortgage rates are more closely linked to long-term rates, such as the
10-year bond rate, than the federal funds rate — which the Federal Reserve, or
Fed, uses to steer the market. In fact, historically, 30-year fixed-rate mortgages
have remained right around 167 basis points higher than the 10-year rate.
The good news for mortgage originators is that the yield curve usually
flattens out during a tightening cycle, which means long-term rates rise
much less than the federal funds rate when the Federal Reserve begins tightening credit. During the last three tightening cycles, the 10-year bond yield
generally increased by less than half of the increase in the federal funds rate
over the same period of time.
In the 1994 tightening cycle, Alan Greenspan raised the federal funds rate
300 basis points over the course of 14 months. This period was famous for
the Orange County bankruptcy and the collapse of several prominent mort-gage-arbitrage hedge funds. During this cycle, the 10-year bond yield increased about 160 basis points, or about 52 basis points for each percentage
point increase in the funds rate.
During the 1999 tightening cycle, the Fed raised the funds rate 175 basis
points, while the 10-year bond yield only increased 70 basis points. This
tightening cycle was famous for pricking the stock market bubble of the
late 1990s. Finally, the 2004 cycle saw a 425 basis-point increase in the
funds rate, with only a 50 basis-point net increase in the 10-year bond yield.
This cycle was the one that burst the residential real estate bubble.
All three times the Federal Reserve tightened credit over the past 20
years, the yield curve flattened. If you average out the percentage increases
in the 10-year bond yield versus the increases in the federal funds rate, you
find that bond yields rise about 34 basis points for each percentage point
increase in the federal funds rate.
If we examine this flattening in the context of the current cycle, we see the
federal funds rate has increased 50 basis points over the 13 months ending
December 2016, from 25 basis points to 75 basis points. The yield on the
10-year bond has risen from 2.2 percent to 2.45 percent, or 25 basis points
as of this past December.
Based on prior cycles, the 10-year bond should be trading closer to
2.3 percent. In fact, if the Fed hikes the funds rate an additional 75 basis
points in 2017, as the Federal Open Market Committee predicted in December 2016, that would imply the 10-year yield would reach 2.65 percent by the
end of 2017. If they hike the fund rate by 50 basis points instead, that implies
a 10-year rate of about 2.55 percent.
And yet, as of early 2017, 10-year bonds are already trading in the
2.5 percent to 2.6 percent range, which means the market is fully discounting those Fed rates hikes as if they had already happened. In other words,
the 10-year may be a little ahead of itself and could take a breather while
the funds rate catches up. While not impossible, it is hard to see how another 75 basis points in the federal funds rate would translate into a rate bump
of 50 to 75 basis points on the 10-year bond.
The stock and bond markets have gone in different directions since
the election, exhibiting the classic “risk-off” behavior where investors
sell safer assets like Treasury bonds and buy riskier assets like stocks.
The Fed baked the possibility of fiscal stimulus measures into its economic projections for 2017, which influenced their forecast for the path
of the funds rate. If we do not see the expected fiscal stimulus out of
Washington, the forecast of three rate hikes is probably too high,
even though the first of those hikes, at 25 basis points, occurred this
It also is important to note that the Fed has been consistently high in its
forecasts for gross domestic product (GDP) growth. A Fed forecast for GDP
growth made in 2014 predicted that 2016 GDP growth would average
between 2.5 percent and 3 percent. That estimate was revised downward
at subsequent meetings. The final forecast made this past December still
had GDP growth for 2016 up close to 2 percent, while the actual growth
came in closer to 1.5 percent.
This has been a pattern since the Great Recession: The expected economic rebound has been weaker than normal. That could be the result of
too much emphasis on recent history. It is important to keep in mind that
this recession is fundamentally different from recessions the country has
experienced since World War II. Those recessions were driven by monetary